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, 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.
can also choose to adopt fiscal policy as an attempt to stabilize the economy.
Fiscal policy has a stabilizing effect on the economy if the budget balance,
the difference between revenue and expenditure, decrease when output falls and
increase when output rises. For example, if output begins to fall, policymakers
can allow tax revenues to fall with income, or even purposely cut tax rates
themselves. This sustains purchasing power and income for individuals and
supports demand. Policymakers could also choose to stimulate demand more by
directly spending more. In any case, a lower surplus or higher deficit essentially
cushions the blow on output.