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

A sovereign's central bank has an inflation target but the government's debt is rising rapidly. A strategist worries about fiscal dominance. Which situation best illustrates fiscal dominance?

Fiscal dominance occurs when high government debt constrains the central bank from tightening, since higher rates would threaten debt sustainability, so monetary policy is effectively driven by fiscal needs. This undermines the inflation mandate and credibility, unlike a bank that tightens despite higher debt service costs.

  1. AThe central bank raises rates to meet its target even though debt service costs for the government rise
  2. BThe central bank is constrained from tightening because higher rates would threaten debt sustainability, so policy is shaped by fiscal needsCorrect
  3. CThe government adopts a fiscal rule limiting deficits and the central bank retains full autonomy
  4. DThe central bank publishes a clear inflation target and explains its decisions regularly

Explanation

Fiscal dominance arises when fiscal needs, such as concern over debt sustainability, limit the central bank's ability to pursue its objective. Raising rates despite debt costs shows monetary dominance, and fiscal rules and transparency support independence.

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