Explain how limited fiscal capacity of a government and high amount of outstanding debt impact the...

Explain how limited fiscal capacity of a government and high amount of outstanding debt impact the ability of the central bank to counteract with risk premium shocks.

Expert Solution

when the central bank will be having a higher amount of outstanding debt and it will also have a limited fiscal capacity, then it will have regular outflows associated with those debt payments and it will mean that when there will be a risk premium shock in the economy, it will not be having the adequate flexibility due to regular payment of the interest on those high outstanding debt.

when the central bank has higher outstanding debt, it is also not having a very high reputation in the global market and there is a low subscription in relation to its bonds so it will not be having a very high raising capability of money and it will also have regular fixed outflows in form of interest payments on the debt outstanding and hence it can be said that it will not have enough flexibility in its hands because when there will be a limited Fiscal capacity than it cannot take risk in relation to exchange rate market and hence it will have a very limited ability in relation to control any kind of risk premium shock because of higher debt outstanding which will be leaving it with a fairly low flexibility.

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