POOLE (1970)

Only with the Bank of England in 1694, did the idea of MP as an independent mechanism first
establish itself. Ever since economists have been trying to reach consensus as to the best course of
action and the recent and ongoing crisis has only fuelled this debate (Gameiro 2011). Friedman and
Hayek, for example debated over the timing of monetary policy and whether it acts to aggravate the
business cycle or not. It is important to first understand however the mechanism of monetary policy
by first looking at goals (Bofinger et al. 2001).

A central bank needs a way of steering the economy to reach its ultimate goal. The ultimate long-
term goals are most often variables such as price stability (argued by Mishkin (1998) as being the
long run overriding goal of monetary policy), high economic growth, low unemployment and
exchange rate stability. Intermediate targets of the money supply and exchange or inflation targets,
which are all observable at shorter time periods, are used to hit these ultimate targets.
However these intermediate targets are not available at sufficiently close intervals. Therefore to steer
the economy onto the correct path that would lead to these intermediate targets (and correspondingly
to these ultimate goals), central banks must choose to keep interest rates constant or the supply of
monetary base constant, both of which can be recorded daily.

Poole (1970) initiated literature on instruments, intermediate targets and these ultimate goals, which
has aided central banks in confronting their underlying problem of which instrument to use. The
problematic nature of this choice was discussed by Canzeroni and Dellas (1998), who showed that
the choice of operating procedure can have a sizeable effect on the average level of the real interest
rate. The model, which Poole (1970) outlined, showed that the stochastic structure of the economy
the nature and relative importance of different types of disturbances would determine the optimal
instrument. This model explains why almost all of todays central banks choose to use the interest
rate operating procedure.

Poole (1970) uses an IS-LM model to explore this issue, and looks at a closed economy,
disregarding inflation, the aggregate supply-side disturbances and expectations. This economy is
described below.

The goods market is described as:

y=-ai+u (IS)

Where y and i are correspondingly the differences between the actual and trend values of output and
interest rates respectively.

The money market is described with:

m=-ci+y+v (LM) (b+hi+w=-ci+y+v)

u and v are stochastic shocks to the goods market and money market, which are unbiased,
homoscedastic and have no autocorrelation.

The objective function to be minimised is the variance in output i.e.

Interest Rate Operating Procedure

Impose i=0 (therefore LM becomes redundant).

Squaring and taking expectations gives:

Monetary Base Operating Procedure




Therefore central banks favour the interest rate operating procedure when the variance of the goods
market shocks (u) is less than the variance of the money market shocks (v).
The gradient of IS and LM also have an impact upon the choices that central banks make. As the LM
becomes steeper and the IS flatter, central banks increase their preference for the interest rate
operating procedure (Walsh 2007).
This preference for the interest rate operating procedure has been the case since the 1980s, when
financial markets began to liberalise and deregulate. These changes in the financial markets meant
noisier money market shocks which were out of the control of central banks, due to the ever more
innovative ways in which banking intermediaries could now extent credit. This preference was no
better illustrated than when the German banks started to follow interest rate operating procedure in
1980s (Posen 1997).

As a result short-term interest rates now play an important role as operating objectives, and have
come to be seen mainly as a way to cope with shocks in the economy, volatility of expectations in
the private financial markets and exchange market pressures (Kneeshaw and Van den Bergh 1989).
The need to make policy signals clearer, due to the increased influence of market forces, born out of
deregulation and liberalisation, and expectations in the formation of interest rates, went hand in hand
with the increased use of interest rates as operating targets (Borio 1997).

Some countries found the gradual transition from implementation arrangements based essentially on
the control of liquidity to a framework in which short term interest rates play a relevant role as an
instrumental variable (Sanz & Val 1993) far easier than others. Where capital markets were already
developed and open market operations had been a major instrument of monetary policy (i.e. the UK
and US), changes in the operating procedure did not take major changes. Countries such as Japan,
Germany and France however underwent far larger monetary control modifications (Batten at el.
1990).

There are criticisms of the model that Poole (1970) presented. Firstly it is only an IS-LM model and
only applies in the short run. Secondly Poole also disregarded inflation, the aggregate supply-side
disturbances and expectations. Thirdly the model assumes that

), so ignoring the
variable k which is the central banks desire to have an output beyond the trend value. This factor k is
the root cause of the inflation bias problem Walsh (1995) discusses in so much depth.
Finally Friedman (1975) went on to address the latter factor that Pooles analysis completely
ignored what happens on the supply-side. A negative supply-side shock (e.g. oil price shock) would
lead to a backwards shift in the SRAS and LRAS, which would lead to an increase in prices and a
fall in output. The real value of the money supply would be suppressed, pushing the LM back,
increasing the interest rates. Monetary targeting would leave the money supply unchanged at the new
equilibrium at y
1
, P
1
and r
1
. If following interest-rate procedure however, in a time-frame where they
are uncertain of the source of shocks, the central bank would be driven wrongly to attribute this
shock to the money markets. They would expand the monetary base (money supply) to revert the LM
back its original output position to prevent the interest rates from rising. This would shift aggregate
demand outwards, ultimately resulting in higher prices and fuelling inflation even more. If they were
to switch to the monetary-base procedure, the interest rate would be higher, which would not be the
best solution, however they would be better off staying there.



There are criticisms of Friedmans argument however. In reality you would hope that central bank
would notice its mistake in the misidentification of the source of the shock due to their constant
meetings and observations. Also if there was a shock, supply side producers are more likely to
simply reduce the workforce hours, then firing them, since the cost of re-hiring and retraining would
be so high.

There are some improvements to the Poole (1970) model. Bernanke et al. (1999) address the
omission of financial frictions as identified by Sheng (2011) and show that inclusion of credit market
imperfections means the credit channel amplifies real and nominal shocks therefore implying that
models of policy instrumental choice such as Poole (1970) are not quite satisfactory.

In conclusion, whilst Pooles model was made under the weak assumption that the central bank is
unable to observe its immediate targets, and does not think about the long run, it has laid a vital
framework for further discussion by Keynesians like Okun (1978) and monetarists like Friedman
(1989). Bisignano (1996) points out that monetary operating instruments and procedures cannot, no
matter how complicated, compensate for an inappropriate choice of policy objective, particularly
with regards to the interest rate and exchange rate, and such sensibly designed policies are still of
critical importance.
Fullwiler (2012) argues QE is not necessarily enhancing bank balance sheets and that in order to
comprehensively more forward, a more detailed understanding is needed of how central bank
operations affect economy in this post-crisis era finance.
This model however does present the central bank with a much-needed compass with which to
steer monetary policy between observations of immediate targets, until they can observe them again.
As Mehrling (2011) says, plumbing matters.