Over a ten-year period, Country X actively managed its currency to ensure it never depreciated by more than 2% annually against the U.S. dollar, and its average inflation rate was 3%. Over the same period, Country Y allowed its currency to float freely, and it experienced an average annual depreciation of 20% against the U.S. dollar, with an average inflation rate of 22%. Based on the typical empirical relationship observed between these two variables, what is the most likely explanation for the difference in inflation rates?

Central Bank Policy Evaluation

Based on the observed empirical relationship between exchange rate movements and price levels, a country that consistently allows its currency to depreciate significantly against a major benchmark currency (like the U.S. dollar) is highly likely to maintain an inflation rate below that of the benchmark currency's country.

Exchange Rate Policy and Domestic Prices