Question

. If central bank wants to meet the objective of stability and money demand is unstable, should it fix money supply or interest?

Answer 1

Money demand is a relationship between money that people want with them and the factors that affect money demand. One of the most important factors affecting money demand is the rate of interest. The rate of interest is like the 'price' of money demanded. Thus, the rate of interest is inversely related to money demand. It is actually the cost of borrowing money. Thus when there is the instability of money demand, the rate of interest is used as a tool of monetary policy to stabilize it.

Central bank thus decreases the rate of interest when they want to increase money demand (as part of consumption and investment) in the economy. And they increase the rate of interest when they want to decrease the money demand (in the form of investment and consumption) in the economy. This is because, at higher interest rates, investments and borrowings will be low and the demand for money will decrease.

Thus we can see that the central bank stabilizes money demand with the help of interest rates. While money supply is just the total assets of money available in the economy and it cannot fix instability in money demand.