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FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust

A central bank has credibly anchored inflation expectations through a long record of meeting its target. How does this credibility most plausibly help it when a supply shock temporarily raises inflation?

Credibility lets the central bank look through a temporary supply shock with a smaller policy response, because anchored expectations limit second-round effects on wages and prices. This reduces the output and financial stability costs of tightening, though it does not prevent the initial price rise.

  1. AIt allows the bank to look through some of the temporary shock without a large rate rise, because expectations stay anchored and second-round effects are limitedCorrect
  2. BIt guarantees that inflation will not rise at all following any shock
  3. CIt forces the bank to raise rates by more than the shock warrants to prove its resolve
  4. DIt removes any need to consider financial stability effects of its policy decisions

Explanation

Anchored expectations reduce the risk that a temporary price shock feeds into wages and prices, so the bank can respond less aggressively, lowering the cost to growth and financial stability. Credibility does not prevent price changes or eliminate other policy considerations.

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