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

A central bank with a price stability mandate faces a supply shock that raises headline inflation while output falls. Which response is most consistent with a mandate-based approach that safeguards long-run credibility?

The mandate-consistent response is to look through the first-round price effects of a supply shock while expectations stay anchored, but respond firmly if de-anchoring or second-round effects appear. This balances output costs with long-run credibility, whereas ignoring inflation or capping yields would erode trust.

  1. AIgnore inflation entirely because the shock is temporary and expectations never matter
  2. BTighten aggressively regardless of output until inflation immediately hits target
  3. CLook through the first-round price effect if expectations remain anchored, but act firmly if signs of de-anchoring or second-round effects emergeCorrect
  4. DCap sovereign yields to keep debt costs low, and let inflation adjust

Explanation

A credible central bank can look through one-off supply effects while watching expectations and second-round effects, acting if these emerge. Ignoring inflation risks de-anchoring, immediate aggressive tightening ignores output costs, and yield caps risk fiscal dominance.

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