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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 objective faces a supply-driven energy price shock that raises headline inflation sharply while output falls. Under a flexible inflation-targeting framework, which response is most consistent with the mandate?

The central bank should let inflation return to target gradually over a longer horizon while ensuring expectations stay anchored. Flexible inflation targeting recognises the output-inflation trade-off from supply shocks, whereas abrupt tightening ignores output costs and sharp easing or dropping the target risks losing credibility.

  1. ATighten aggressively at once to return inflation to target within one quarter, ignoring output
  2. BCut rates sharply to offset the output loss regardless of inflation expectations
  3. CAllow a gradual return of inflation to target over a longer horizon while monitoring that expectations stay anchoredCorrect
  4. DAbandon the inflation target until the shock has passed

Explanation

Flexible inflation targeting acknowledges the trade-off created by supply shocks and permits a medium-term return to target, provided expectations remain anchored. Immediate aggressive tightening ignores output costs. Sharp cuts risk de-anchoring expectations. Abandoning the target destroys credibility.

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