Working Paper: NBER ID: w1049
Authors: Charles Engel; Jeffrey A. Frankel
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.
Keywords: money supply; interest rates; foreign exchange market
JEL Codes: E5; F3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| money supply announcements (E51) | market expectations of future monetary policy (E60) |
| increase in money supply perceived as deviation from target growth (O42) | expectations of future tightening (E66) |
| expectations of future tightening (E66) | appreciation of the dollar (F31) |
| increase in money supply (E51) | higher target growth rate (O42) |
| higher target growth rate (O42) | expected inflation rises (E31) |
| expected inflation rises (E31) | higher nominal interest rate (E43) |
| higher nominal interest rate (E43) | depreciation of the dollar (F31) |
| liquidity effect (E41) | changes in interest rates (E43) |