CFA Level I · CFA Level I Exam · Fiscal Policy
An economy has a large government debt, and the central bank buys government bonds to keep yields low and finance the deficit, with money growth rising sharply. The greatest risk of this interaction is most likely:
The greatest risk is loss of central bank independence and higher inflation. Monetizing the deficit means money creation is driven by government financing needs rather than price stability goals, and fast money growth tends to push up inflation expectations and actual inflation.
- AFalling inflation as the budget deficit narrows
- BLoss of central bank independence and higher inflationCorrect
- CLower aggregate demand from higher real interest rates
Explanation
When the central bank finances the deficit by creating money, monetary policy serves fiscal needs, undermining independence and credibility. Rapid money growth tends to raise inflation. Higher real rates and a narrowing deficit contradict the described actions.
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