Question

using a graph of money supply and demand, explain why a policy of setting a constant interest rate could be destabilizing

Answer 1

Interest rate targeting is destabilizing because interest rate clears the money market, loanable funds market and overall financial frictions by changing its value. When interest rate is kept at a fixed value and there is a change in money demand, the central bank has to regularly change in the money supply to keep the rate of interest unchanged. This destabilizes the economy because central bank often ends up either overstimulating the heated economy or drags down the sluggish economy.

For example, suppose the economy is suffering from recession and government raises its spending to stimulate the economy. AD shifts to the right in goods market and both output and price level reach their long run values. But this raises the rate of interest which is required to be kept at its target value. Central bank intervenes and increases money supply to reduce the rate of interest. In goods market, this shifts AD further to the right, creating an inflationary gap. In this way, keeping the interest rate target destabilizes the economy.