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Why money announcements move interest rates: an answer from the foreign exchange market

  • Engel, Charles
  • Frankel, Jeffrey

On a Friday that the Fed announces a money supply greater than had been anticipated, interest rates move up in response. Why? One explanation is that the market perceives the fluctuation in the moneystock as an unintended deviation from the Fed's target growth rate that will be reversed in subsequent periods. The anticipation of this future tightening drives up interest rates today. A second explanation is that the market perceives the increase in the money supply as signalling a higher target growth rate. The expected future inflation rate rises,which is reflected in a higher nominal Interest rate.This paper offers grounds for choosing between the two possible explanations: evidence from the exchange market. Under the first explanation, anticipated future tightening, one would expect the dollar to appreciate against foreign currencies. Under the second explanation,expected inflation, one would expect it to depreciate. We render these claims more concrete by a formal model, a generalization of the Dornbusch overshooting model. Then we use the mark/dollar rate toanswer the question. We find a statistically significant tendency for the dollar to appreciate following positive money supply surprises.This supports the first explanation.

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Article provided by Federal Reserve Bank of San Francisco in its journal Proceedings.

Volume (Year): (1982)
Issue (Month): 6 ()
Pages: 1-36

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Handle: RePEc:fip:fedfpr:y:1982:i:nov:p:1-36
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  1. Granger, C W J, 1969. "Investigating Causal Relations by Econometric Models and Cross-Spectral Methods," Econometrica, Econometric Society, vol. 37(3), pages 424-38, July.
  2. Frankel, Jeffrey A, 1979. "On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials," American Economic Review, American Economic Association, vol. 69(4), pages 610-22, September.
  3. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  4. Frenkel, Jacob A, 1976. " A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence," Scandinavian Journal of Economics, Wiley Blackwell, vol. 78(2), pages 200-224.
  5. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-82, June.
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