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

A risk analyst argues that persistent large fiscal deficits may complicate the central bank's fight against inflation. Which mechanism best supports this argument?

Large and rising government debt can lead to fiscal dominance, where the central bank is pressured to keep rates low to limit debt servicing costs. That undermines the credibility of its inflation commitment and can de-anchor inflation expectations.

  1. AExpanding government debt can raise concerns about fiscal dominance, where the central bank is pressured to keep rates low to contain debt servicing costs, weakening inflation credibilityCorrect
  2. BLarger deficits always lower aggregate demand and so reduce inflation
  3. CHigher government debt makes sovereign bonds risk-free regardless of the policy rate
  4. DFiscal deficits are irrelevant to inflation expectations when central bank independence exists on paper

Explanation

With high debt, higher rates raise interest costs and create pressure to ease, risking fiscal dominance and de-anchored expectations. Deficits generally add to demand, not reduce it, so the other options are wrong.

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