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Suppose that, as the chair of the Fed, you decide to "put policy on automatic pilot" and require that monetary policy follow an established rule. When might each of the following two rules be appropriate? (a) Maintain a constant interest rate. (b) Maintain a constant money supply.

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A constant interest rate is emphasized and discussed in the solution.

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Question A
In order to keep the interest rate constant, the automatic pilot should adjust the money supply so that it always equates the money demand at the desired interest rate. This means that the money supply will have to increase when money demand increases, and fall when money demand falls. Changes in the money supply, however, can lead to unwanted inflationary pressures (when money supply rises) or deflationary pressures in the opposite case. Thus, a constant interest rate policy is only appropriate when ...

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