By (Name)

The Name of the School

The City and State
1st March, 2024
1.

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 Assignment
1. Equation Explanations:
About equation (1),
y t = y 0−ait +ut … … … (1)

This denotes the output equation of Poole’s model. The output y t is influenced by the rate of
interest it and a random variable ut .The term ai t represents the impact of the rate of interest on
utput.
Whereby:
y 0 denotes the initial value of y t

ai t denotes the trend component , where ' a ' represents therate of change of y t with resepect ¿ time t

ut denotesthe random disturbance∨error term , which introduces variabilty∨noise∈¿ thempde

Also, about equation (2),

mt =m0+ by t−ci t + v t … … … ( 2 )
Whereby:
m0 denotes theintital value of mt

by t denotes the a trend component

ci t denotes thst might decrease the value of mt withtime t .

v t denotes the random disturbances term for mt and is also assumed to have a mean of zero and
variance of σ 2u. And it is independent of ut as indicated by the zeros ccovariances between ut
and v t

The equation is known as the “money supply equation” in Poole’s model. The money supply mt
is impacted by the rate of interest i t , the output y t , and a random variable v t. The terms by t and
−ci t represent the impacts of the output and the rate of interest on the money supply,
respectively.
Hence in respect to the, question, the bank’s goal is to lessen the loss function
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Lt =E ( y t ) , which means it wants to minimize the expected value of the square of the output.
This could be interpreted as the bank wanting to reduce the variability of the output.
The loss Function: equation.

The central bank's objective is to minimize the loss function, Lt , which measures the expected
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squared deviation of y t from its optimal value. This is represented as: Lt =E ( y t ) .The expectation

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operator E(⋅) calculates the average value of y t , and squaring it ensures that both positive and
negative deviations from the optimal value are penalized equally.
2. Analysis on rate of interest targeting regime.

In the rate of interest targeting regime, the central bank sets the rate of interest it and lets
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the money supply mt adjust accordingly. The goal is to reduce the loss function Lt =E ( y t ) ,
which is the expected value of the output square.

y t = y 0−ait +ut

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To get the minimum loss, the expected value of ( y t ) with respect to (i)

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The Bank, desires to minimize the loss function Lt =E ( y t ) , then replacing of y t ,

2
: E Lt =E ( y t )

2
E Lt =E ( y 0−ai t +ut )

E ( y t )=E [ y 0 ( y 0−ai t +ut )−ait ( y 0−ai t +u t ) +u t ( y 0−ai t + ut ) ]

( y t )=E [ y 0 − y 0 ai t + y 0 ut − y 0 ait + ( ai t ) −ai t ut + y 0 u t−ait u t +ut ]

2 2 2

E ( y t )=E [ y 02 −2 y 0 ai t + 2 y 0 ut + ( ai t )2−2 ait u t +ut 2 ]

2 2 2
E ( y t )=E y 0 −2 E y 0 ai t +2 E y 0 u t + E ( ai t ) −2 E ai t ut + E u t

But since E ut =0∧E ut2=σ 2u , hence the equation results to:

2 2 2
E ( y t )=E y 0 −2 E y 0 ai t +0+ E ( ai t ) −0+σ u ,

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But Lt =E ( y t ) thereby :

2 2 2
Lt = y 0 −2 y 0 ai t + ( ai t ) + σ u ,

2 2 2
For the bank to minimise Lt , this Lt = y 0 −2 y 0 ait + ( ai t ) + σ u , is differentiated with respect to (i)

d Lt 2
=−2 y 0 ai t + 2 ait =0
di

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 y0
But ai=
t

Hence,

( )
2
2 y0 y0 2
Lt = y 0 −2 y 0 + +σ u ,
t t t t

2 2 2 2
Lt = y 0 −2 y 0 + y 0 + σ u ,

2 2
Lt =2 y 0 + σ u ,

Hence, this shows that cap E u sub t equals 0 , a. n d , superscript base , cap E u sub t , end base ,
squared equals , sigma sub u squared, for minimising the loss function under the targeting
regime with the interest rate Thereby the minimum loss obtainable under an interest targeting
regime is Lt =2 y 02+ σ 2u ,

3. Analysis on the monetary targeting regime

Under a monetary targeting regime, the bank sets m to achieve the minimum loss, and the
expected value of y t 2 is to be minimised with respect to m. using equation (1) y t = y 0−ait +ut ,
hence getting the optimal m that minimises the loss is done as follows:

Equitation 1: y t = y 0−ait +ut

Given that the central bank follows a monetary targeting regime, where mt =m, and the expected
value i t can be expressed as a function of the constants and the monetary aggregate m . Using the
loss function:

2
Lt =E ( y t )

2
Lt =E ( y 0−ait +ut )

Lt =E [ y 0 ( y 0−ai t + ut ) −ai t ( y 0 −ai t +ut ) +ut ( y 0 −ai t +ut ) ]

Lt =E [ y 02− y 0 ai t + y 0 ut − y 0 ai t + ( ai t )2−ai t u t + y 0 ut −ai t ut + ut2 ]

Lt =E [ y 02−2 y 0 ai t +2 y 0 u t + ( ait )2−2 ai t ut + ut2 ]

2 2 2
Lt =E y 0 −2 E y 0 ait +2 E y 0 ut + E ( ai t ) −2 E ait u t + E ut

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Nevertheless, since E ut =0∧E ut2=σ 2u , hence the equation results to:

2 2 2
E ( y t )=E y 0 −2 E y 0 ai t +0+ E ( ai t ) −0+σ u ,

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But Lt =E ( y t ) thereby :

2 2 2
Lt = y 0 −2 y 0 ai t + ( ai t ) + σ u ,

Minimizing Lt with respect to m

Therefore, to minimise the loss under monetary targeting regime, the equation of Lt with respect
to m

mt =m0+ by t−ci t + v t

Then since y t = y 0−ait +ut then:

mt =m0+ b ( y 0−ai t +ut )−ci t + v t

mt =m0+ b y 0−b ai t +b ut −cit + v t

Hence getting optimal m

Differentiating Lt with respect with m hence setting the equation equal to zero

d Lt d mt
=0 , differentiating, leads ¿ =0
dm dm

d mt
Differentiating for mt with respect to m:
dm

d Lt d
=
dm dm
( y 02−2 y 0 ai t + ( ait ) +σ 2u , )+
2

dm (
d m0+ b y 0−b ait +b ut −cit + v t
1 )
Since m0 , b y 0 ,b ait ,b u t , ci t∧v t are all constants with respect to m, their derivatives are zero.
So, the derivative reduces to:

d
( v )=0
dm t

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The random disturbances v tis independent of m, so its derivative with respect to m is zero.
Therefore, no constraint on m from this equation. The first derivative doesn’t involve m; its
derivative concerning m is zero. Thus, the considered derivative is the second term:

hence :

dm (
d m0 +b y 0−b ai t +b u t−cit +v t
1
=0 )
d
( y 2 −2 y 0 ait +( ait )2 +σ 2u ,)=0
dm 0

This derivative, differentiated with respect to m, and the derivative depends on constants terms
2
y 0∧σ u. So its derivative with respect to mis zero. thereof there exists no constraints on m from
the minimization of Lt . Hence under a monetary targeting regime, the differentiated loss
obtainable is the same as the rate of interest targeting regime, which is 2 y 02+ σ 2u ,

2 2
Lt =2 ai y 0 −a i

Hence, the minimum loss obtainable under a monetary targeting regime depends on the optimal
choice of parameter a , which determines the sensitivity of output to changes in the rate of
interest. This sensitivity influences the central bank's ability to stabilize the economy and achieve
its policy objectives.

Factors influencing the choice of the optimal policy instrument

In the model, the economy is subject to two types of shocks: exogenous shocks represented by
ut ∧v t, and endogenous shocks arising from the central bank's policy actions. Exogenous shocks
are unpredictable and arise from factors outside the control of the central bank, such as changes
in technology, natural disasters, or shifts in consumer preferences. An endogenous shock,
however, is a result of the decision of the central bank and its influence on the economy.

The Best Policy Instrument

In a rate of interest targeting regime, the bank pegs the rate of interest to stabilize the economy.
The optimal policy instrument resulting from the analysis is that the central bank does not react
to output changes if it targets rate of interests. However, It does not go into details regarding
alternative policy measures and concentrates mainly on the rate of interest manipulation to reach
its goals. This tactic may depend on the type of shocks the economy faces. In case shocks of
exogenous type prevail, like abrupt changes in the global economic situation or geopolitical
events, rising with output fluctuations, the rate of interest volatility may increase, and the central

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bank’s ability to sustain the economy will be weakened. In such situations, a stable rate of
interest can serve as a reference point which can stabilise expectations and induce stability in the
economy.

Policy Implications

a) Rate of interest Targeting

The analysis also showed that under the rate of interest targeting regime, the optimal policy
instrument is to be set, indicating that the central bank does not respond when targeting a rate of
interest. A stable rate of interest environment provides predictability and certainty to financial
markets and households.

b) Monetary Targeting

In the same way, when the regime is monetary targeting, the optimal policy instrument shows
that the central bank does not react to the output fluctuations when the money supply is the
target. Control over the money supply enables the central bank to affect the growth rate of the
economy’s aggregate nominal spending and, in the process, suppress inflationary pressures.

Overall Policy Implications

The results have demonstrated the relevance of choosing the right type of policy tool, taking into
account actual economic conditions and the central bank’s policy objectives. The decision on
which instrument is the most effective depends on the central bank's assessment regarding the
degree of importance of exogenous and endogenous shocks and the capacity of the central bank
to influence the economy through its policy actions. Central banks can ensure long-term
sustainable growth and stability by making monetary policy consistent with the current state of
the economy and policy goals.