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

A risk officer at a bank reads that a central bank has a clearly defined primary mandate of price stability, with operational independence from the government in setting interest rates. Which outcome is the most direct benefit of this institutional design for financial market participants?

The main benefit is better anchored inflation expectations. A clear price-stability mandate with operational independence makes the central bank's commitment credible, which lowers the inflation risk premium embedded in long-term yields. It does not eliminate sovereign default risk or provide cheap deficit financing.

  1. ALower credibility of inflation targets because the bank is insulated from elected officials
  2. BBetter anchoring of long-term inflation expectations, reducing inflation risk premia in long-dated yieldsCorrect
  3. CGuaranteed elimination of sovereign default risk
  4. DAutomatic financing of government deficits at below-market rates

Explanation

Independence and a clear price-stability mandate make the commitment to low inflation credible, which anchors expectations and lowers the inflation risk premium in long-term yields. Independence increases rather than reduces credibility. It does not remove sovereign default risk, and monetary financing of deficits is what independence is designed to prevent.

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