As inflation rises, even governments previously committed to budget discipline are spending freely to help households. Higher interest rates announced by central banks are supposed to help produce modest fiscal austerity, because to maintain stable debts while paying more to borrow, governments must cut spending or raise taxes. Without the fiscal backup, monetary policy eventually loses traction. Higher interest rates become inflationary, not disinflationary, because they simply lead governments to borrow more to pay rising debt-service costs. The risk of monetary unmooring is greater when public debt rises, because interest rates become more important to budget deficits.

Which of the following statements best reflects the most logical and rational inference/inferences that can be made from the passage?
1. Central banks cannot bring down inflation without budgetary backing.
2. The effects of monetary policy depend on the fiscal policies pursued by the government.
Select the correct answer using the code given below.

The correct option is Both 1 and 2.

Let us analyze the passage step-by-step to understand why both inferences are logical and rational:

Analysis of Statement 1: "Central banks cannot bring down inflation without budgetary backing."
The passage explicitly states: "Without the fiscal backup, monetary policy eventually loses traction." It further explains that in the absence of fiscal backup (budgetary backing), higher interest rates (monetary policy) "become inflationary, not disinflationary, because they simply lead governments to borrow more to pay rising debt-service costs." Since monetary policy loses traction and becomes inflationary instead of disinflationary without fiscal backing, we can logically infer that central banks (which control monetary policy) cannot successfully bring down inflation without budgetary backing. Therefore, Statement 1 is a valid inference.

Analysis of Statement 2: "The effects of monetary policy depend on the fiscal policies pursued by the government."
The passage describes how central banks announce higher interest rates (monetary policy) to produce modest fiscal austerity. However, if the government continues to spend freely and does not cut spending or raise taxes (fiscal policy), the higher interest rates end up causing the government to borrow more to pay debt-service costs, making the policy inflationary rather than disinflationary. Thus, whether monetary policy succeeds in being disinflationary or ends up being inflationary depends directly on the fiscal policies (budget discipline, spending, and taxing decisions) pursued by the government. Therefore, Statement 2 is also a valid inference.

Since both Statement 1 and Statement 2 are logically backed by the passage, the correct code is Both 1 and 2.