Final answer:
Ignoring the Taylor principle can result in unstable inflation as inadequate interest rate responses boost aggregate demand disproportionately, creating a self-reinforcing cycle of rising prices, leading to market inefficiency and economic planning difficulties.
Step-by-step explanation:
Not adhering to the Taylor principle, which suggests that central banks should raise nominal interest rates by more than the increase in inflation, can lead to instability in inflation. This is because, in the aggregate demand and supply (AD/AS) model, if policy makers fail to increase interest rates sufficiently when inflation rises, the real interest rate (that is, the nominal interest minus inflation) actually declines, potentially boosting aggregate demand more than is appropriate given the state of the economy.
When aggregate demand persistently outpaces aggregate supply, it tends to push the economy's output beyond its potential and the price level higher, thus fuelling inflation. This situation can be exacerbated by the expectations of economic agents. If consumers and businesses begin to anticipate higher inflation because they observe that policy makers are not responding aggressively enough to rising inflation, they will likely adjust their price setting, wage demands, and contract negotiations accordingly, which can lead to a self-perpetuating cycle of rising prices.
Without adherence to the Taylor principle, in the long run, the instability can manifest in high and variable inflation, which undermines the ability of markets to adjust effectively, leading to more prevalent surpluses and shortages, and impairing long-term economic planning.