Difficulty level mostly affects HP (novice=1/2, squire=3/4, veteran=nl, adept=5/4, champion=3/2); some games like Secret it'll affect your ability to run away from random encounters. Occasionally the number of enemies is affected (as in the boss fight in Dave's Challenge in Death Knights of Krynn). In the first few games it affected XP, but you only got a few more--they were going by the standard XP/HP formula in the 1e DMG. Goldbox, particularly near the beginning, was big on being tabletop-accurate--that was the whole point of the series, to play D&D on your computer.
The exact formula has been figured out, by Stephen S. Lee:
https://gamefaqs.gamespot.com/pc/564785-pool-of-radiance/faqs/73869
It's 0.4*cleric levels + 0.8*mage levels + 0.5*(AC below 0) + 0.5* (THAC0 below 21) + 0.1*HP.
Yes, this means you can walk around with your armor unreadied and run into smaller enemy parties.