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

A risk manager at a bond fund notes that a central bank has raised rates to fight inflation while the government continues large deficits financed by short-term debt. Which is the most likely channel through which this combination heightens fiscal-dominance risk?

Higher rates raise refinancing costs on short-term government debt, which reprices quickly. Rising debt service strains public finances and increases pressure on the central bank to ease, which heightens fiscal-dominance risk and raises doubts about its inflation commitment.

  1. AHigher rates raise the government's refinancing costs, increasing debt service and pressure on the central bank to easeCorrect
  2. BHigher rates directly lower the government's primary deficit through automatic stabilisers
  3. CShort-term debt insulates the government from rate increases
  4. DHigher rates reduce the real value of outstanding fixed-rate debt, worsening sustainability

Explanation

Short-maturity debt reprices quickly, so higher policy rates pass fast into interest costs, worsening the fiscal position and increasing political pressure on the central bank. Short debt does not insulate; and inflation eroding real fixed-rate debt would help, not hurt, the government.

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