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CFA Level I · CFA Level I Exam · Monetary Policy

A central bank is financing persistent government deficits by creating money, and investors begin to expect higher future inflation. The most likely effect of this loss of credibility is that:

Rising inflation expectations are the most likely result. Financing deficits through money creation erodes central bank credibility, so investors demand higher nominal yields to compensate for expected inflation, and bringing inflation back down later becomes more costly in lost output.

  1. Ainflation expectations rise, pushing up nominal bond yields and making disinflation costlierCorrect
  2. Bthe central bank gains greater independence from political influence
  3. Creal output rises permanently because money creation lowers the natural rate of unemployment

Explanation

Monetizing deficits undermines credibility, so expectations of inflation rise, which raises nominal yields through the inflation premium and makes later disinflation more costly. It does not increase independence, and money creation cannot permanently lower the natural unemployment rate.

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