A country maintains a flexible exchange rate, but its central bank is widely perceived as lacking independence and a firm commitment to price stability. If this country is hit by a significant external inflationary shock, such as a global surge in commodity prices, what is the most probable combined effect on its currency and domestic price level?

An economy with a flexible exchange rate and a central bank that lacks a credible commitment to price stability is hit by a significant inflationary shock (e.g., a surge in global energy prices). Arrange the following economic events into the most likely causal sequence that demonstrates how the currency's movement can amplify the initial shock.

Analyzing Currency Response to an Inflationary Shock

The Destabilizing Role of Exchange Rates

The Role of Expectations in Currency-Driven Inflation

In an economy with a flexible exchange rate system but a central bank that is widely perceived to lack independence, a significant, unexpected rise in the global price of essential imports will typically lead to an appreciation of the domestic currency.

In an economy with a flexible exchange rate and a central bank that is not perceived as independent, an external inflationary shock can trigger a destabilizing feedback loop. Match each economic component to its specific role in this process.

In an economy with a flexible exchange rate and a central bank that lacks a credible commitment to price stability, a depreciation of the domestic currency following an external price shock does not act as a stabilizer but instead ________ the initial inflationary pressure.

Policy Response to an Inflationary Shock

Consider two countries, both with flexible exchange rate systems, that are hit by an identical, significant, and unexpected increase in the global price of a crucial imported commodity. Country A's central bank is highly independent and has a strong, credible reputation for maintaining price stability. Country B's central bank is widely seen as lacking independence and has a history of failing to control price pressures. Based on this information, which statement best contrasts the most likely immediate reaction of their respective currencies?