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

A central bank is concerned about 'fiscal dominance'. Which situation best illustrates it?

Fiscal dominance is when high public debt and financing needs constrain the central bank, so it hesitates to tighten policy to fight inflation for fear of destabilising government finances. This undermines monetary independence and can erode trust in price stability.

  1. ALarge public debt makes the central bank reluctant to raise rates to control inflation because doing so would threaten debt sustainabilityCorrect
  2. BThe government adopts a rule capping its deficit at 3% of GDP
  3. CThe central bank raises rates independently despite a high inflation rate
  4. DFiscal authorities delegate tax collection to an independent agency

Explanation

Fiscal dominance arises when fiscal needs constrain monetary policy, so the central bank's inflation objective is compromised by debt service concerns. Deficit caps and independent rate decisions are the opposite of dominance.

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