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

Which policy mix would most likely be consistent with restoring monetary dominance in an economy where inflation has risen and public debt is high?

Credible fiscal consolidation best restores monetary dominance, because it lets the central bank raise rates to fight inflation without raising doubts about debt sustainability. Yield caps, rate cuts to fund spending, or abandoning the inflation target would instead subordinate monetary policy to fiscal financing needs.

  1. ACredible fiscal consolidation that allows the central bank to tighten without threatening debt sustainabilityCorrect
  2. BCentral bank purchases of government debt to cap yields while inflation exceeds target
  3. CFiscal expansion financed by lower policy rates
  4. DSuspending the inflation target during debt stress

Explanation

Monetary dominance requires that fiscal policy supports debt sustainability so rate increases do not create solvency concerns. Capping yields, cutting rates to fund spending or dropping the target all subordinate monetary policy to fiscal needs, reinforcing fiscal dominance.

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