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

During a period of high inflation, a central bank must decide whether to keep tightening even though some non-bank financial institutions are showing stress from higher rates. Which statement best describes the policy trade-off, and the usual way of addressing it?

Price stability and financial stability can pull in opposite directions in the short run. Authorities typically assign the policy rate to inflation and use targeted liquidity support or macroprudential tools to contain financial stress, rather than abandoning the inflation objective.

  1. APrice stability and financial stability can conflict in the short run; authorities typically use the policy rate for inflation and targeted liquidity or macroprudential tools for stressCorrect
  2. BFinancial stability always requires cutting rates, so inflation targets must be abandoned
  3. CPrice stability and financial stability never conflict, so no separate tools are needed
  4. DFiscal policy cannot affect inflation, so the central bank must rely solely on the policy rate for all objectives

Explanation

Tightening to control inflation can expose vulnerabilities, creating a short-run tension. The common approach is to separate instruments: the interest rate targets inflation while liquidity facilities and macroprudential measures address stress. Claiming no conflict or always cutting rates misstates the trade-off.

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