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The Poole model extends the IS-LM
model to include uncertainty or shocks. If there were no shocks either setting
i, interest rates, or M, money supply, would achieve the target Y, GDP, there
is no problem over the choice of monetary instrument. But, setting M requires
additional knowledge of money demand, whereas i only requires knowledge of the
IS curve. The aim of Monetary Authority is to minimize output volatility (Poole,
1970), the difference in output volatility between the two regimes generally
depends on certain characteristics of the economy. The Central Bank can either
choose to set the stock of money and let the interest rate be decided by the
interaction of money demand and supply, or it can set the interest rate and let
the supply of money be determined by the demand for money.

 

The IS curve is defined as Y=a0+a1r+m and the LM curve is defined as               M= b1+b1 Y+b2r+n. M and Y are defined as the
logarithms of money supply and output. b0, b1, b2, a0 and a1 are
parameters and r is the interest rate. There are three standard assumptions
which apply: b1 >0, b2 su then an interest rate rule would be
preferred. Money supply rule versus interest rate rule is highly dependent on
the model parameters
b1 and the volatility of n and m, empirical evidence should also be used if
possible to back up the claim for the use of either rule.

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Fiscal
policy may also be used by policymakers in an attempt to stabilize the economy.
This is done through either increasing or decreasing government spending or
raising or lowering taxes. Lowering taxes can help to improve consumption in an
economy and thus increase aggregate demand. If the tax cuts are financed by
reductions in unproductive government spending this can boost output. However,
if the they are not financed through tax cuts this will lead to an increase in government
borrowing, which will hinder economic growth in the long run. One of the big
advantages of using fiscal policy over monetary policy is that the effect is
felt much sooner in the economy compared to monetary policies which have large
time lags (Gruen, Romalis and Chandra, 1999). Increasing government spending is
very beneficial if the economy experiences an unexpected shock to investment,
this could be due to firms having a pessimistic view of the economy. The aim of
this is to stimulate the economy and bring output back to the equilibrium level,
however if the government does not have large reserves and has to borrow to
finance this it may not be the best option.

 

In
conclusion, to reduce volatility central banks must identify whether the shock
is coming from the money markets or the real economy. If the economy is
experiencing money demand shocks fixing the interest rate is a better choice as
it fixes output and the volatility in financial markets does not matter.
However, if the economy is experiencing private spending shock fixing money
supply is the preferred choice as it acts as an automatic stabilizer of the
interest rate.

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