FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust
A central bank's inflation is above target, but it simultaneously sees stress in nonbank financial institutions that would be worsened by further rate hikes. Which policy approach best reflects the reading's emphasis on separating the monetary stance from financial stability tools?
The best approach keeps the policy rate focused on returning inflation to target while deploying targeted liquidity support and macroprudential tools to contain nonbank stress. This separates the monetary stance from stability interventions and protects central bank credibility against fiscal dominance or loss of anchoring.
- AContinue tightening to achieve the inflation target while using targeted liquidity facilities and macroprudential tools to address market dysfunction without altering the stanceCorrect
- BPause tightening indefinitely and use asset purchases to cap yields, regardless of inflation
- CCut policy rates to relieve nonbank stress, accepting higher inflation as a necessary cost
- DAbandon the inflation target in favor of a financial stability target
Explanation
The 'separation principle' holds that rates address inflation while liquidity backstops and macroprudential measures address stability stress. Open-ended yield caps or rate cuts risk undermining credibility and fiscal dominance concerns. Abandoning the target also erodes trust in the framework.
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