On the Feasibility of Interest Rate Control: The Role of Disequilibrium and Adaptive Learning

A model is constructed which derives an inverse relationship between real rate of interest and inflation rate following a disproportionate change in money supply. It is argued that such an inverse relationship paves the way for successful control of the nominal interest rate. It is analytically demonstrated that the state space is divided by a separatrix containing a stable zone and an unstable zone. If the initial inflation and the dynamics of inflationary expectations lie in the stable zone, then the monetary authority can peg the nominal interest rate without risking runaway inflation or deflation. The unstable zone, however, keeps the possibility of the cumulative process alive.