Assessed Coursework

ECON30852

Deadline: Wednesday, 13 March 2024,

Submit on Turnitin before 2pm

Consider the following problem, based on a simplified version of Poole (1970),

(William Poole, 1970. Optimal choice of monetary policy instruments in a
simple stochastic macro model, Quarterly Journal of Economics 84, 197-216):

yt = y0 − ait + ut (1)
mt = m0 + byt − cit + vt (2)

where ut and vt are independent random variables (i.e., Cov(u, v) = 0), with
zero mean and variances, σu2 and σv2 , respectively. y0 and m0 are constant terms
in these two equations respectively. Assume that the central bank wants to
minimize the loss function,
2
Lt = E (yt ) . (3)

1. Explain these equations [6 marks];

2. Find analytically the minimum loss obtainable under an interest rate tar-
geting regime [22 marks];
3. Find analytically the minimum loss obtainable under a monetary targeting
regime [22 marks];
4. Using your results in 2 and 3 above, discuss how the choice of the optimal
policy instrument depends on the nature of the shocks, and discuss the
policy implications of these results. [50 marks].

Particular attention must be given to the theoretical explanation and eco-

nomic intuition of all your equations and results. Please provide the full deriva-
tion of your results, with explanations of all steps taken to arrive at each solu-
tion. Results without evidence of their derivation, even if correct, will receive
no credit.

IMPORTANT NOTES

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1. This assessed coursework counts for 25% of your final mark for this
course.
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——————–

2
 By (Name)

The Name of the School

The City and State
1st March, 2024

1
 Assignment
1. Equation Explanations:
About equation (1),
𝑦𝑡 = 𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 … … … (1)

This denotes the output equation of Poole’s model. The output yt is influenced by the rate of
interest it and a random variable ut . The term ait represents the impact of the rate of interest on
utput.
Whereby:

𝑦0 denotes the initial value of 𝑦𝑡

𝑎𝑖𝑡 𝑑𝑒𝑛𝑜𝑡𝑒𝑠 𝑡ℎ𝑒 𝑡𝑟𝑒𝑛𝑑 𝑐𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡, 𝑤ℎ𝑒𝑟𝑒 ′𝑎′ 𝑟𝑒𝑝𝑟𝑒𝑠𝑒𝑛𝑡𝑠 𝑡ℎ𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑐ℎ𝑎𝑛𝑔𝑒 𝑜𝑓 𝑦𝑡 𝑤𝑖𝑡ℎ 𝑟𝑒𝑠𝑒𝑝𝑒𝑐𝑡 𝑡𝑜 𝑡𝑖𝑚𝑒

𝑢𝑡 𝑑𝑒𝑛𝑜𝑡𝑒𝑠 𝑡ℎ𝑒 𝑟𝑎𝑛𝑑𝑜𝑚 𝑑𝑖𝑠𝑡𝑢𝑟𝑏𝑎𝑛𝑐𝑒 𝑜𝑟 𝑒𝑟𝑟𝑜𝑟 𝑡𝑒𝑟𝑚, 𝑤ℎ𝑖𝑐ℎ 𝑖𝑛𝑡𝑟𝑜𝑑𝑢𝑐𝑒𝑠 𝑣𝑎𝑟𝑖𝑎𝑏𝑖𝑙𝑡𝑦 𝑜𝑟 𝑛𝑜𝑖𝑠𝑒 𝑖𝑛 𝑡𝑜 𝑡ℎ𝑒 𝑚𝑝𝑑

Also, about equation (2),

𝑚𝑡 = 𝑚0 + 𝑏𝑦𝑡 − 𝑐𝑖𝑡 + 𝑣𝑡 … … … (2)

Whereby:
𝑚0 𝑑𝑒𝑛𝑜𝑡𝑒𝑠 𝑡ℎ𝑒 𝑖𝑛𝑡𝑖𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑚𝑡

𝑏𝑦𝑡 𝑑𝑒𝑛𝑜𝑡𝑒𝑠 𝑡ℎ𝑒 𝑎 𝑡𝑟𝑒𝑛𝑑 𝑐𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡

𝑐𝑖𝑡 𝑑𝑒𝑛𝑜𝑡𝑒𝑠 𝑡ℎ𝑠𝑡 𝑚𝑖𝑔ℎ𝑡 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑚𝑡 𝑤𝑖𝑡ℎ 𝑡𝑖𝑚𝑒 𝑡.

𝑣𝑡 denotes the random disturbances term for 𝑚𝑡 and is also assumed to have a mean of zero
and variance of 𝜎𝑢2 . And it is independent of ut as indicated by the zeros ccovariances between
ut and vt

The equation is known as the “money supply equation” in Poole’s model. The money supply mt
is impacted by the rate of interest it , the output yt , and a random variable vt . The terms byt and
−cit 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
𝐿𝑡 = 𝐸(𝑦𝑡 )2, 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
squared deviation of 𝑦𝑡 from its optimal value. This is represented as: 𝐿𝑡 = 𝐸(𝑦𝑡 )2 . The
expectation operator E(⋅) calculates the average value of 𝑦𝑡 , and squaring it ensures that both
positive and negative deviations from the optimal value are penalized equally.

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 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
the money supply mt adjust accordingly. The goal is to reduce the loss function 𝐿𝑡 = 𝐸(𝑦𝑡 )2,
which is the expected value of the output square.

𝑦𝑡 = 𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡

To get the minimum loss, the expected value of (𝑦𝑡 )2with respect to (𝑖)

The Bank, desires to minimize the loss function 𝐿𝑡 = 𝐸(𝑦𝑡 )2, then replacing of 𝑦𝑡 ,

: 𝐸𝐿𝑡 = 𝐸(𝑦𝑡 )2

𝐸𝐿𝑡 = 𝐸(𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 )2

𝐸(𝑦𝑡 ) = 𝐸[𝑦0 (𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 ) − 𝑎𝑖𝑡 (𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 ) + 𝑢𝑡 (𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 )]

(𝑦𝑡 ) = 𝐸[𝑦0 2 − 𝑦0 𝑎𝑖𝑡 + 𝑦0 𝑢𝑡 − 𝑦0 𝑎𝑖𝑡 + (𝑎𝑖𝑡 )2 − 𝑎𝑖𝑡 𝑢𝑡 + 𝑦0 𝑢𝑡 − 𝑎𝑖𝑡 𝑢𝑡 + 𝑢𝑡 2 ]

𝐸(𝑦𝑡 ) = 𝐸[𝑦0 2 − 2𝑦0 𝑎𝑖𝑡 + 2𝑦0 𝑢𝑡 + (𝑎𝑖𝑡 )2 − 2𝑎𝑖𝑡 𝑢𝑡 + 𝑢𝑡 2 ]

𝐸(𝑦𝑡 ) = 𝐸𝑦0 2 − 2𝐸𝑦0 𝑎𝑖𝑡 + 2𝐸𝑦0 𝑢𝑡 + 𝐸(𝑎𝑖𝑡 )2 − 2𝐸𝑎𝑖𝑡 𝑢𝑡 + 𝐸𝑢𝑡 2

But since 𝐸𝑢𝑡 = 0 𝑎𝑛𝑑 𝐸𝑢𝑡 2 = 𝜎𝑢2 , hence the equation results to:

𝐸(𝑦𝑡 ) = 𝐸𝑦0 2 − 2𝐸𝑦0 𝑎𝑖𝑡 + 0 + 𝐸(𝑎𝑖𝑡 )2 − 0 + 𝜎𝑢2 ,

But 𝐿𝑡 = 𝐸(𝑦𝑡 )2 𝑡ℎ𝑒𝑟𝑒𝑏𝑦:

𝐿𝑡 = 𝑦0 2 − 2𝑦0 𝑎𝑖𝑡 + (𝑎𝑖𝑡 )2 + 𝜎𝑢2 ,

For the bank to minimise 𝐿𝑡 , 𝑡ℎ𝑖𝑠 𝐿𝑡 = 𝑦0 2 − 2𝑦0 𝑎𝑖𝑡 + (𝑎𝑖𝑡 )2 + 𝜎𝑢2 , is differentiated with
respect to (i)

𝑑𝐿𝑡
= −2𝑦0 𝑎𝑖𝑡 + 2𝑎𝑖𝑡 2 = 0
𝑑𝑖
𝑦0
But 𝑎𝑖 = 𝑡

Hence,

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 𝑦0 𝑦0 2
𝐿𝑡 = 𝑦0 2 − 2𝑦0 + ( ) + 𝜎𝑢2 ,
𝑡𝑡 𝑡𝑡

𝐿𝑡 = 𝑦0 2 − 2𝑦0 2 + 𝑦0 2 + 𝜎𝑢2 ,

𝐿𝑡 = 2𝑦0 2 + 𝜎𝑢2 ,

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 = 2𝑦0 2 + 𝜎𝑢2 ,

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 𝑦𝑡 2 𝑖s to be minimised with respect to m. using equation (1) 𝑦𝑡 = 𝑦0 − 𝑎𝑖𝑡 +
𝑢𝑡 , hence getting the optimal m that minimises the loss is done as follows:

Equitation 1: 𝑦𝑡 = 𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡

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

𝐿𝑡 = 𝐸(𝑦𝑡 )2

𝐿𝑡 = 𝐸(𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 )2

𝐿𝑡 = 𝐸[𝑦0 (𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 ) − 𝑎𝑖𝑡 (𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 ) + 𝑢𝑡 (𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 )]

𝐿𝑡 = 𝐸[𝑦0 2 − 𝑦0 𝑎𝑖𝑡 + 𝑦0 𝑢𝑡 − 𝑦0 𝑎𝑖𝑡 + (𝑎𝑖𝑡 )2 − 𝑎𝑖𝑡 𝑢𝑡 + 𝑦0 𝑢𝑡 − 𝑎𝑖𝑡 𝑢𝑡 + 𝑢𝑡 2 ]

𝐿𝑡 = 𝐸[𝑦0 2 − 2𝑦0 𝑎𝑖𝑡 + 2𝑦0 𝑢𝑡 + (𝑎𝑖𝑡 )2 − 2𝑎𝑖𝑡 𝑢𝑡 + 𝑢𝑡 2 ]

𝐿𝑡 = 𝐸𝑦0 2 − 2𝐸𝑦0 𝑎𝑖𝑡 + 2𝐸𝑦0 𝑢𝑡 + 𝐸(𝑎𝑖𝑡 )2 − 2𝐸𝑎𝑖𝑡 𝑢𝑡 + 𝐸𝑢𝑡 2

Nevertheless, since 𝐸𝑢𝑡 = 0 𝑎𝑛𝑑 𝐸𝑢𝑡 2 = 𝜎𝑢2 , hence the equation results to:

𝐸(𝑦𝑡 ) = 𝐸𝑦0 2 − 2𝐸𝑦0 𝑎𝑖𝑡 + 0 + 𝐸(𝑎𝑖𝑡 )2 − 0 + 𝜎𝑢2 ,

But 𝐿𝑡 = 𝐸(𝑦𝑡 )2 𝑡ℎ𝑒𝑟𝑒𝑏𝑦:

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𝐿𝑡 = 𝑦0 2 − 2𝑦0 𝑎𝑖𝑡 + (𝑎𝑖𝑡 )2 + 𝜎𝑢2 ,

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 + 𝑏𝑦𝑡 − 𝑐𝑖𝑡 + 𝑣𝑡

Then since 𝑦𝑡 = 𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 𝑡ℎ𝑒𝑛:

𝑚𝑡 = 𝑚0 + 𝑏(𝑦0 − 𝑎𝑖𝑡 + 𝑢𝑡 ) − 𝑐𝑖𝑡 + 𝑣𝑡

𝑚𝑡 = 𝑚0 + 𝑏𝑦0 − 𝑏𝑎𝑖𝑡 + 𝑏𝑢𝑡 − 𝑐𝑖𝑡 + 𝑣𝑡

Hence getting optimal m

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

𝑑𝐿𝑡 𝑑𝑚𝑡
= 0, 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑡𝑖𝑛𝑔 𝑖𝑡, 𝑙𝑒𝑎𝑑𝑠 𝑡𝑜 =0
𝑑𝑚 𝑑𝑚
𝑑𝑚𝑡
Differentiating 𝑓𝑜𝑟 𝑚𝑡 with respect to m:
𝑑𝑚

𝑑𝐿𝑡 𝑑 𝑑 𝑚0 + 𝑏𝑦0 − 𝑏𝑎𝑖𝑡 + 𝑏𝑢𝑡 − 𝑐𝑖𝑡 + 𝑣𝑡

= (𝑦0 2 − 2𝑦0 𝑎𝑖𝑡 + (𝑎𝑖𝑡 )2 + 𝜎𝑢2 , ) + ( )
𝑑𝑚 𝑑𝑚 𝑑𝑚 1

Since 𝑚0 , 𝑏𝑦0 , 𝑏𝑎𝑖𝑡 , 𝑏𝑢𝑡 , 𝑐𝑖𝑡 𝑎𝑛𝑑 𝑣𝑡 are all constants with respect to m, their derivatives are
zero. So, the derivative reduces to:

𝑑
(𝑣 ) = 0
𝑑𝑚 𝑡

The random disturbances 𝑣𝑡 is 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:

𝑑 𝑚0 + 𝑏𝑦0 − 𝑏𝑎𝑖𝑡 + 𝑏𝑢𝑡 − 𝑐𝑖𝑡 + 𝑣𝑡

( )=0
𝑑𝑚 1

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 𝑑
(𝑦 2 − 2𝑦0 𝑎𝑖𝑡 + (𝑎𝑖𝑡 )2 + 𝜎𝑢2 , ) = 0
𝑑𝑚 0

This derivative, differentiated with respect to m, and the derivative depends on constants terms
𝑦0 𝑎𝑛𝑑 𝜎𝑢2 . 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 2𝑦0 2 + 𝜎𝑢2 ,

𝐿𝑡 = 2𝑎𝑖𝑦0 − 𝑎2 𝑖 2

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 𝑎𝑛𝑑 𝑣𝑡 , 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
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
6
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.