Question

Explain in your own word why targeting interest rates is so difficult for central banks if the demand for money is unstable.

Answer 1

Central bank is the banker of banks. It keeps check on interest rates to stabilize them. It increases interest rates when there is inflation in the country so as to control the demand on the other hand when there is slowdown in the economy, it decreases interest rates so that loan can be cheaper, demand can be increased, production can increase, employment can increase and economy can grow.

Targeting interest rates is so difficult for central banks if the demand for money is unstable because if money supply increases, value of money decreases and it gives birth to inflation while on the other hand if money supply decreases, value of money increases, it is not easy for central bank to target the interest rates if money supply keep fluctuating.

The easiest way to conduct the monetary policy is, Open market operations, if monetary supply moves up and down, it becomes difficult to achieve the monetary targets.