Optimal Choice of Monetary Policy Instruments Economics Assessed Coursework Consider the Poole (1970) model (W. Poole, 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 y0 and m0 are constant terms in the IS and LM curve respectively. Assume that the central bank wants to minimize the loss function
Lt =E(yt)2: (3)
- The minimum loss obtainable under an interest rate targeting regime (30
marks);
- The minimum loss obtainable under a monetary targeting regime (30 marks);
- Using your results in 1 and 2 above, discuss how the choice of the optimal policy instrument depends on the nature of the shock (40 marks).
Particular attention must be given to the theoretical explanation and economic intuition of all your equations and results. Please provide the full derivation of your results, with explanations of all steps taken to arrive at each solution. Results without evidence of their derivation, even if correct, will receive no credit.
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