Such a policy can make financial instability less likely. In my view, the reason that this is so resides once again in the informational asymmetries that pervade our financial system. For example, in an economy that experiences severe swings in output growth, lenders will be more reluctant to lend and will demand higher interest rates because of the higher risks that borrowers will default.
But this situation is likely to exacerbate the adverse selection problem, as only riskier borrowers will be willing to take out loans at higher interest rates. Similarly, in an environment of high inflation, lenders will not be willing to lend for long periods. Debt contracts will then tend to have short maturities, thereby increasing the system's exposure to cash flow and liquidity problems.