Essay On Poole Model

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The Poole Model is a macroeconomic model where its main objective is to answer the discussion on whether monetary policy should be conducted using a money-supply rule or an interest-rate rule when managing the economy. In the Poole Model, the Central Bank’s objective is to minimize the loss function:
L = E [(Y - Yf )2
The Poole Model extends the IS-LM model where it takes shocks into account. The monetary authority can either decide to set interest rates which would allow money supply to be determined by demand; or it could directly set the money supply, which would allow the interest rate to be determined by supply and demand for money. The aim of both of these is to minimize output volatility. Under these two methods, the level of output volatility is dependent on specific characteristics of the economy.
Setting the rate of interest (i) creates a …show more content…

Shocks to spending will cause the IS curve to shift. Spending shocks directly change the aggregate demand at each interest rate and also the level of income. This impact of a spending shock is shown below. Due to the spending shock, the IS function may lie anywhere between IS1 and IS2. If a money-supply rule is implemented, then the money supply will be set at M*(Yf). This would cause the LM function to be set at LM1 and cause aggregate demand to vary between Y1 and Y2. However, should the monetary authorities choose to set interest rate at r*, then the LM function will be LM2. This would result in aggregate demand varying from anywhere between Y0 and Y3. The diagram shows us that there is a problem when deciding which monetary policy to use when there is shocks to spending. This problem would be solved by setting the money supply at M* (Yf), whilst letting the interest rate fluctuate as it will. Along with this, if policy makers are only concerned with volatility in the goods market, then the money-supply rule is better as it has automatic stabilizers built

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