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

A central bank with a primary price stability mandate and a secondary financial stability role faces a surge in inflation while sovereign debt is high and bond yields are rising. A portfolio manager asks what outcome is most consistent with 'fiscal dominance' risk. Which scenario fits?

Fiscal dominance fits the scenario where the central bank hesitates to tighten because higher rates would worsen government debt servicing and sovereign stress. Fiscal needs then constrain monetary policy, weakening inflation control and the credibility of the price stability mandate.

  1. AThe central bank raises rates sharply because the government has committed to a credible consolidation plan
  2. BThe central bank hesitates to tighten because higher rates would worsen debt servicing and sovereign stress, weakening its inflation controlCorrect
  3. CThe government cuts spending to give the central bank more room to ease
  4. DThe central bank sells reserves to defend the exchange rate peg

Explanation

Fiscal dominance arises when debt sustainability concerns constrain monetary policy, so the central bank is reluctant to tighten. This undermines the price stability objective and trust. Credible consolidation does the opposite.

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