In an open economy, a shift to nominal interest rate targeting would lead to complete economic instability

One may wonder whether central banks in OECD countries are switching to a policy of targeting nominal interest rates. This is explicitly the case in Japan. But we note also that the Federal Reserve and the ECB are very anxious to avoid undesirable movements in long-term interest rates. The problem is that in an open economy with flexible exchange rates: If the central bank sets the nominal interest rate according to inflation by “ overindexing ” it to inflation (the real interest rate rises if there is more inflation), the economy is stable and the exchange rate corrects short-term demand shocks to get the economy back to the long-term equilibrium; But if the central bank has a fixed nominal interest rate policy, the economy is unstable, since in the short term any exchange rate is compatible with convergence towards the long-term equilibrium: there may be huge short-term variability in the exchange rate, since in reality it is indeterminate. For instance, if the exchange rate depreciates too much, then production and inflation increase, the real interest rate falls (as the nominal interest rate does not move) and the exchange rate therefore appreciates anew to maintain interest rate parity: any initial movement in the exchange rate is then corrected. This instability (indeterminacy) argument should discourage the use of a nominal interest rate target for monetary policy in the absence of barriers to capital mobility.