The can set the interest rate and let the

The Poole model extends the IS-LM
model to include uncertainty or shocks. 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 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 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 <0 and a1<0. The IS and LM equations are expanded with unpredictable shock terms m and n. These unpredictable shock terms have the four following properties: Em=0, En=0,  Em2=s2m and En2=s2 .The first two assumptions state that the mean of the shocks are zero, however this does not mean that shocks are not expected and the last two state that their variances are constant. m is a shock to the IS curve, for example an increase in investor confidence, this leads to higher spending and so equilibrium GDP increases all else equal. n is a shock to the LM curve and money demand in particular. In bad times liquid assets are preferred, so money demand is higher as individuals have less confidence in a bond being paid back due to the possibility of the company or government defaulting. The Central Bank objective is minimize the loss function: L=E(Y-Yf)2. This means that equal losses occur if the economy's output is below or above the target, Yf. Figure 1 represents an economy experiencing money demand shocks only. A money demand increase is a reflection of pessimism as individual's would rather hold liquid assets, however this is most likely pessimism in real economic terms for example consumption and investment may be low. In bad times money demand is volatile so the LM curve is volatile as well, this also means that the IS curve will have an element of volatility. In economic bad times the increasing demand for cash causes interest rates to go up endogenously under the money supply rule which lowers real spending, this only makes the problem worse. However, if you fix the interest rate the only financial variable that is driving the economic components of GDP is the interest rate, this isn't changing as it's fixed so nothing changes as far as GDP is concerned, liquidity preference and stock of money do not matter as they do not enter the determinants. This implies that volatility in financial markers does not matter, which is a key strength for the interest rate rule over the money supply rule. If this is how the economy is working than an interest rate rule would be a better choice than a money supply rule.       Figure 2 represents an economy with private spending shocks only. In this case it is the IS curve giving you volatility rather than the LM curve. This could be due to economic investment being volatile which there is plenty of evidence to suggest it is, estimates of it being 17-18% of GDP in the UK. So in a bad year no one will invest and the IS curve will be low and in a good year lots of people will so the IS curve will be high. With a fixed money supply rule you have an advantage of a stabilizing influence to an extent. In good times GDP will be higher so interest rates will go up, this is beneficial as it offsets any exuberance from the private sector. Whereas, in bad times interest rates will fall to offset any pessimism that the private sector may have. There will still be macroeconomic volatility when there is volatility to the real economy but this is offset to an extent by changing interest rates. As seen in figure 2, fixing interest rates leads to greater macroeconomic volatility as GDP varies between Y_'' to Y+'', whereas with a fixed money supply rule GDP only varies between Y_' to Y+'.  So in this case a fixed money supply rule would be better due to it being an automatic stabilizer of the interest rate. markets and the real economy. Firstly figure 3 where the IS curve is volatile, under a money supply rule volatility is less than the interest rate rule as the IS curve shocks are bigger, this is shown by the differences in horizontal displacement between Y_' to Y+' and Y_'' to Y+''. This means that interest rates are acting in the desired way as they are increasing during good times and decreasing during bad times, to reduce the spending shock. The interest rate is the key element of why the money supply rule is preferred in this circumstance given the objective of minimizing volatility. Now for figure 4 where the LM curve is volatile, under a money supply rule volatility is greater than the interest rate rule, this is shown by the differences in horizontal displacement between Y_' to Y+' and Y_'' to Y+''. The key point is what the interest rate is doing as this is what links the financial sector to the real economy. The interest rates are not behaving in a coherent way as they are decreasing in good times and increasing in bad times which exacerbates the problem. This is why an interest rate rule is preferred in this circumstance over a monetary supply rule.   The horizontal displacement of the IS and LM curves helps to determine which policy you should choose, as output volatility is costly as it reduces investment in the long run. The horizontal displacement of the IS curve is equal to m and the horizontal displacement of the LM curve is equal to –(n/b1), where b1  is the income elasticity of money demand. Money demand shocks may not matter that much if b1 is high enough. The LM curve shifts up when you enter economic bad times which means interest rates may be going up and GDP may be going down for other reasons for example the IS curve. If GDP is going down money demand will go down which leads to an offsetting effect, in bad times n goes up but b1Y goes down. This means that if b1 is high enough it could write off the increase in n. Level of income is another determinant of the position of the LM curve, so in bad times income levels fall which offsets to an extent the increase in the LM curve. The horizontal displacement of the LM curve depends on the relationship between GDP and interest rates governed by the financial sector. If  < su  then a money supply rule would be preferred, whereas if  > 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.