FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust
A central bank with a price stability mandate observes that inflation expectations among households and firms have risen well above its target, even though current inflation is only modestly elevated. Which statement best describes the main risk to the bank's mandate if it fails to respond?
Unanchored inflation expectations are the main risk. If households and firms expect higher inflation, they build it into wages and prices, so inflation becomes self-perpetuating and bringing it back to target later requires costlier tightening with greater output and employment losses.
- AExpectations may become unanchored, making disinflation later more costly in terms of output and employmentCorrect
- BHigher expectations will automatically reduce nominal wage demands and lower inflation
- CThe central bank's balance sheet will shrink mechanically, reducing its policy room
- DFiscal deficits will fall because nominal tax revenues rise faster than spending
Explanation
Credibility rests on anchored expectations. If expectations drift up, they feed into wage and price setting, so a later return to target requires tighter policy and larger real costs. Higher expectations do not reduce wage demands; they raise them.
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