Why Money Announcements Move Interest Rates: An Answer from the Foreign Exchange Market

Charles Engel and Jeffrey Frankel

No 1049, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: 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.

Date: 1982-12
Note: ITI IFM
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Published as Charles Engel & Jeffrey Frankel, 1982. "Why money announcements move interest rates: an answer from the foreign exchange market," Proceedings, Federal Reserve Bank of San Francisco, issue Nov, pages 1-36.
Published as "Why interest rates react to money announcements *1: An explanation from the foreign exchange market." Journal of Monetary Economics, Volume 13, Issue 1, January 1984, Pages 31-39
Published as Reprinted in On Exchange Rates, J. Frankel, MIT Press, 1993

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