FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust
A central bank faces a government whose debt has grown so large that raising policy rates sharply would push public debt service to unsustainable levels. Markets begin to doubt that the central bank can tighten enough to hold inflation at target. Which term best describes this situation?
This is fiscal dominance. When public debt is so high that tightening policy would threaten debt sustainability, fiscal needs constrain the central bank's ability to control inflation. Under monetary dominance the opposite holds: fiscal policy adjusts to a credible central bank.
- AFiscal dominanceCorrect
- BMonetary dominance
- CRicardian equivalence
- DLiquidity trap
Explanation
Fiscal dominance arises when fiscal needs constrain monetary policy, so the central bank's ability to pursue its price stability objective is compromised by debt sustainability concerns. Monetary dominance is the opposite, where fiscal policy adjusts to a credible central bank.
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