Because of high loan-to-deposit ratios, domestic banks’ market risk had increased. (The real economy) Domestic business activity shrank rapidly as a mood of unease came on top of the global credit crunch, the consequent worldwide economic recession, and the worsening foreign exchange market. The subdued state of domestic demand in terms of consumption and investment intensified while exports declined abruptly.
This line of reasoning shows that the simple policy rule (4) is not capable of implementing complete stabilisation unless the natural rate is constant. Unlike in the simple model considered so far, monetary policy will in general not be able to guarantee full stabilisation at all times.