Monetary disequilibrium is an imbalance between the quantity of money and the demand to hold money. In the long run, monetary disequilibrium is corrected by an adjustment of the price level. However, it isn't solely the prices of consumer goods and services that must adjust, or even all final goods and services. The prices of the various resources used to produce goods and services must also adjust. That includes labor, so wages must change as well.
Until prices and wages adjust, monetary disequilibrium can lead to disturbances to interest rates, output, and employment. There is a plausible market process by which an imbalance between the supply and demand for money leads to an almost immediate change in interest rates. There is substantial evidence that such an impact exists, which is called the "liquidity effect."
Consider a shortage of money--the quantity of money is less than the demand to hold money. Some of those short on money can rapidly solve their problem by selling bonds that are traded on organized exchanges. The prices on such exchanges adjust almost continuously to clear the market. The shortage of money rapidly leads to lower bond prices and higher bond yields. "The" market interest rate increases.
Of course, whoever bought the bonds is now short on money. Because money serves as medium of exchange, there can be no assumption that people buying bonds for money do so because they want to permanently decrease their money holdings.
Further, some households or firms short on money may not own any bonds. They might restrict their expenditures out of current receipts to build up their money holdings. Then those who had planned to sell them goods, services or assets, will be short of money. At least some of them may own bonds and sell them.
If the interest rate that can be earned on money is "sticky," and perhaps stuck at zero for hand-to-hand currency, then higher market interest rates increase the opportunity cost of holding money. This makes holding money less attractive. Loosely following Keynes, a very short run equilibrium might exist where the market interest rate adjusts enough so that the demand to hold money adjusts to the existing quantity of money.
From a monetary disequilibrium approach, this sort of very short run adjustment in market interest rates does not correct monetary disequilibrium rather it is one of many aspects of monetary disequilibrium. Assuming the market interest rate was appropriately coordinating saving and investment before, then the market interest rate has been pushed above the "natural interest rate," and saving and investment are no longer be balanced.
There will be a tendency for spending on both consumer goods and capital goods to slow. This tends to disrupt both production and employment, though it does provide a signal and an incentive for firms to adjust their pricing strategies, including the wages they offer workers, in a way that eventually corrects the monetary disequilibrium.
Suppose a monetary authority is seeking to adjust the quantity of money to the demand to hold it, and a shortage of money develops. One early sign that a problem has developed would be an increase in market interest rates. Expanding the quantity of money would relieve the shortage of money, allowing "the" market interest rate to fall back to the natural interest rate.
If the natural interest rate never changed, as long as all imbalances between the quantity of money and the demand to hold money had at least some "liquidity effect" on interest rates, then a monetary authority should be able to adjust the quantity of money to the demand by keeping "the" market interest rate stable. Increase the quantity of money when "the" market interest rate rises, and decrease the quantity of money when "the" market interest rate falls.
Traditionally, monetarists have been critical of this approach because market interest rates can also change due to changes in the supply or demand for credit. For example, firms might perceive attractive investment opportunities and sell bonds to fund the purchase of capital goods. This increase in the demand for credit would tend to depress bond prices and increase bond yields.
If a monetary authority were to increase the quantity of money to prevent this increase in the market interest rate it would be creating a surplus of money. There was no increase in the demand to hold money, rather there was an increase in the demand by firms to spend money. When the monetary authority increases the quantity of money to prevent market interest rates from rising, it would be causing the quantity of money to rise beyond the demand to hold it. As long as some of those with excess money used it to purchase bonds, then this would create a "liquidity effect" on market interest rates. However, this time, the liquidity effect is keeping interest rates from rising.
Using the framing of the natural interest rate, when firms perceive new investment opportunities, the increase in the demand for investment leads to a higher natural interest rate. The efforts of firms to finance their investments creates market forces that tend to raise market interest rates along with the natural interest rate. With the monetary authority targeting interest rates, it interferes with those market forces, creating a surplus of money that prevents the market rate from rising with the natural interest rate.
From this perspective, with the monetary authority seeking to keep the quantity of money equal to the demand to hold money, and avoid disturbances to interest rates, real output, or the price level due to monetary disequilibrium, then it is very important to determine what is causing changes in interest rates. Were they caused by changes in the supply or demand for credit? That is, does it reflect a change in the natural interest rate? Or were the changes in market interest rates due to changes in quantity of money or the demand to hold it?
The rule for action seems simple. The monetary authority should allow the market interest rate change with the natural interest rate. The market interest rate should change to keep saving and investment in balance. In other words, changes in supply and demand conditions for credit should result in changes in market interest rates so that the amount of loans supplied and demanded match.
It is certainly possible that having a monetary authority that tries to forecast the natural interest rate and adjusts a target for the yield on a short term money market instrument would have more success than one that tries to forecast the demand for some measure of the quantity of money and adjusts the quantity of that measure of money to meet that demand. There is substantial evidence from the Great Moderation the the first approach is less prone to error than the second.
Is that why central banks throughout the world target interest rates? Is it because it is less error prone than targeting the quantity of money in service of providing monetary stability?
Consider an alternative approach to understanding central banks. Investment bankers not only market stocks and bonds for their clients, they also underwrite them. The investment bankers borrow short, give the money to the firms or governments that need the money, and then sell off stocks or bonds issued by their clients.
From the perspective of the investment bankers, being able to borrow at stable (and I would think low,) short term interest rates is desirable. A spike in short term interest rates will add to their costs and reduce their profits.
Does it matter why the spike interest rates occurred? Perhaps to some small degree, but not very much.
So, an investment banker has an agreement with a client to underwrite $100 million in long term bonds. It needs to borrow a little less than $100 million to pay to the client.
If the demand to hold money were to rise, and a shortage of money causes all sorts of people currently holding short term bonds to sell them, this would be a very poor time for the investment banker to sell short term bonds. A central bank that increased the quantity of money, purchasing all of the short term bonds that were being, would fix the investment banker's problem.
If the demand for credit were to rise, but there was no shortage of money at all, then all sorts of firms would be selling bonds, competing for a limited supply of credit. A monetary authority, that stabilized interest rates by increasing the quantity of money, purchasing all of the short term bonds sold by those demanding more credit, would also fix the investment banker's problem.
Consider a large money center commercial bank. It funds its loan portfolio with a variety of short term to maturity liabilities. If short term interest rates rise, it reduces the commercial bank's profitability--at least if it is lending at fixed interest rates. Does it matter from the commercial bank's perspective whether the reason for increase in interest rates was a decrease in the supply or increase in the demand for credit, or else an imbalance between the quantity of money and the demand to hold it? From its perspective, the problem is the same. A central bank that creates more money to keep interest rates from rising solves the problem.
If investment banks and money-center commercial banks are special interests that impact the selection of the leaders of central banks, then it should be no surprise that central banks target interest rates. From the perspective of the "public good," that is, avoiding monetary disequilibrium, some changes in market interest rates should be avoided, but others allowed. But from the perspective of the special interests of investment banks and money-center commerical bankers, creating excess supplies of money to prevent interest rates from rising is very much a good thing.
Of course, the long run effect of keeping interest rates too low is higher inflation. A policy of keeping nominal interest rates low and stable in the face of rising inflation will lead to hyperinflation. So, keeping interest rates "too low" for "too long" will end up requiring a central bank to raise interest rates even higher in the future.
From the perspective of the special interest of bankers, then, the goal should be to keep interest rates stable, subject to the constraint that inflation, and more importantly, inflation expectations, not increase. To the degree that investment and money center commercial bankers are a special interest group that influences the leadership of central bank, we should anticipate a focus on short term interest rates. And that is exactly what we observe.