Using the inflation differential between two countries to forecast their exchange rates is not always accurate because of such factors as the uncertain timing of the impact of inflation and barriers to trade.

Question

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Using only inflation differential to forecast exchange rates can be unreliable as other factors can have a significant influence on the foreign exchange market, such as trade barriers, political stability, and interest rates. Additionally, the impact of inflation on a currency's value may not be immediately felt, and there can be lags in the adjustment process.

Using the Inflation Differential Between Two Countries to Forecast Their