A considerable volume of research shows that asset prices respond to changes in the Federal Reserve's discount rate. While several competing hypotheses have been advanced to explain the market's response to discount rate announcements, comparatively little effort has been made to differentiate among alternative hypotheses. The result is an abundance of evidence establishing that asset prices respond to discount rate announcements, but little if any agreement about why markets respond. This article attempts to fill a void in the literature by pointing out how competing hypotheses differ and by constructing tests explicitly designed to differentiate among competing explanations. The evidence suggest that the market's reaction to discount rate changes is purely an announcement effect, i.e., a reaction to new information contained in the announcement, that the direct effect of discount rate changes on market rates is nil, that the announcement effect is invariant to the Federal Reserve's operating procedure and that, generally speaking, changes in the discount rate do not signal a change in monetary policy. The announcement effect appears to vary with both the nature and extent of the information that the announcement of a discount rate change is believed to contain.
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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number
1994-032.
Length: Date of creation: 1996 Date of revision: Publication status: Published in Journal of Banking and Finance, January 1998 Handle: RePEc:fip:fedlwp:1994-032
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Adrian R. Pagan & John C. Robertson, 1995.
"Resolving the liquidity effect,"
Proceedings,
Federal Reserve Bank of St. Louis, issue May, pages 33-54.
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