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

A risk manager is assessing the case for central bank independence. Which argument best explains why an independent central bank with a clear price stability objective supports macro-financial stability?

Independence mitigates the time-inconsistency problem. Because the central bank is shielded from short-term political pressure to boost activity ahead of elections, its commitment to price stability is more credible, anchoring expectations. Financing deficits would instead weaken credibility and raise risk premia.

  1. AIt lets the bank finance government deficits at preferred rates, lowering sovereign risk premia
  2. BIt reduces the time-inconsistency problem by insulating policy from short-term political pressure to stimulate before electionsCorrect
  3. CIt removes the need for any coordination with fiscal authorities during crises
  4. DIt guarantees that policy rates never need to change in response to supply shocks

Explanation

Independence addresses time inconsistency: politicians may favour short-run stimulus that raises inflation later. Insulation makes the commitment to low inflation credible. Financing deficits is monetary dominance by fiscal needs, which undermines trust.

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