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Working Paper 8406
MONETARY POLICY AND REAL INTEREST RATES:
NEW EVIDENCE FROM THE MONEY STOCK ANNOUNCEMENTS
by W i l l i a m T. Gavin
and Nicholas V . Karamouzis

Working papers o f t h e Federal
Reserve Bank o f Cleveland are
p r e l iminary m a t e r i a l s, c i r c u l a t e d t o
s t i m u l a t e discussion and c r i t i c a l comment.
The views s t a t e d h e r e i n a r e those o f
t h e authors and n o t n e c e s s a r i l y those
o f t h e Federal Reserve Bank o f Cleveland
o r o f t h e Board o f Governors of t h e
Federal Reserve System.

W i l l i a m T. Gavin i s an economist a t t h e
Federal Reserve Bank o f C l eve1and.
Nicholas V. Karamouzis i s an a s s i s t a n t
professor, Department o f Economics,
Case Western Reserve U n i v e r s i t y , and
a v i s i t i n g schol ar, Federal Reserve
Bank o f Cleveland.
The authors wish t o thank Raymond
Lombra and t h e i r colleagues f o r t h e i r
many he1pfuf comments.
December 1984
Federal Reserve Bank o f Cleveland

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MONETARY POLICY AND REAL INTEREST RATES:
NEW EVIDENCE FROM THE MONEY STOCK ANNOUNCEMENTS

This paper presents new evidence on how a s s e t p r i c e s respond t o new
i n f o r m a t i o n about the money stock.

I t shows t h a t the i n f o r m a t i o n c o n t e n t o f

money stock announcements and t h e response of a s s e t p r i c e s t o new i n f o r m a t i o n
i n t h e announcements vary w i t h changes i n the monetary p o l i c y regime, t h e
Federal Reserve o p e r a t i ng procedures, and t h e reserve accounti ng r u l e s .

Whi 1e

previous s t u d i e s have examined how asset p r i c e s respond t o t h e money stock
announcements under t h e i n t e r e s t - r a t e t a r g e t i n g procedure and t h e nonborrowed
r e s e r v e procedure, we have in c l uded new evidence from t h e borrowed reserve
t a r g e t i n g procedure under b o t h 1agged and contemporaneous reserve accounting
rules.

Looking a t how both forward exchange r a t e s and o t h e r a s s e t p r i c e s

respond t o the announcements, we d i s t i n g u i s h between periods when the
a s s e t - p r i c e response r e f l e c t e d a change i n t h e r e a l i n t e r e s t r a t e and those
when i t r e f l e c t e d a change i n t h e i n f l a t i o n premium.

F i n a l l y , we show t h a t

t h e new contemporaneous reserve accounting r u l e s have g r e a t l y reduced t h e
i n f o r m a t i o n c o n t e n t o f the money stock announcements.

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I. I n t r o d u c t i o n

The e x p l i c i t examination o f expectations has been a r e c e n t i m p o r t a n t
development i n economic theory and p o l i c y .

Studies have emphasized t h e

importance o f t h e m a r k e t ' s p e r c e p t i o n o f and r e a c t i o n t o new i n f o r m a t i o n about
economic p o l i c y .

I n p a r t i c u l a r , i n t h e area o f monetary economics, one o f t h e

ongoing debates has been over whether monetary p o l i c y can a f f e c t long- term
real i n t e r e s t rates.

The r e s o l u t i o n o f t h i s debate depends, t o a l a r g e

extent, on how markets respond t o perceived changes i n monetary pol i c y .

While

t h e r e have been many t h e o r e t i c a l and e m p i r i c a l s t u d i e s o f t h i s issue, t h e most
r e c e n t examination can be found i n several papers t h a t i n v e s t i g a t e t h e
response o f asset p r i c e s t o weekly money stock announcements.

1

The announcement s t u d i e s a r e based on t h e e f f i c i e n t market hypothesis,
which s t a t e s t h a t t h e c u r r e n t asset p r i c e w i l l r e f l e c t a l l p u b l i c l y a v a i l a b l e
Changes i n p r i c e s should r e f 1e c t o n l y new i n f o r m a t i o n .

information.

The

e m p i r i c a l model used i n s t u d i e s o f money stock announcements takes t h e
f o l l o w i n g form:

where
hAit

= change i n t h e ith
asset p r i c e from b e f o r e t h e

announcement t o a f t e r the announcement,
UMt = s u r p r i s e i n t h e money stock announcement a t time t,

EMt = expected change i n t h e money stock a t time t, and
e = random e r r o r .

I f t h e e f f i c i e n t market hypothesis i s t r u e , i f we have accurate measures o f

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expectations, and i f t h e money stock i s an i m p o r t a n t f a c t o r i n determining t h e
p r i c e o f the asset, then al w i l l be s i g n i f i c a n t and ap w i l l be zero.
A r e s u l t common t o a l l of these announcement s t u d i e s i s t h a t estimates o f

al are p o s i t i v e when i n t e r e s t r a t e s a r e used as t h e dependent v a r i a b l e i n
equation 1.

Several hypotheses have been presented t o e x p l a i n t h i s p o s i t i v e

c o r r e l a t i o n between money stock s u r p r i s e s and changes i n i n t e r e s t r a t e s .
These hypotheses can be c l a s s i f i e d i n t o two broad categories.

The f i r s t

a t t r i b u t e s t h e p o s i t i v e value o f al t o an i n f l a t i o n premium t h a t changes
because t h e money stock s u r p r i s e i s t r e a t e d as a money supply shock.

The

second a t t r i b u t e s the p o s i t i v e value o f al t o a p o l i c y a n t i c i p a t i o n e f f e c t .
The money stock s u r p r i s e i s t r e a t e d as a money demand shock t h a t i s expected
t o be o f f s e t by f u t u r e p o l i c y actions.
I n t h i s paper we p r o v i d e new evidence t o e x p l a i n how asset p r i c e s have
responded t o s u r p r i s e s i n t h e money stock announcement over t h e p a s t seven
years.

Our sample period, September 1977 t o September 1984, was determined by

the a v a i l a b i l i t y o f survey data on t h e expected change i n t h e money stock.
The p e r i o d i n c l u d e s i m p o r t a n t changes i n monetary p o l i c y and o p e r a t i n g
procedures.

We d i s t i n g u i s h between p o l i c y regime changes and o p e r a t i n g

procedure changes, which are n o t n e c e s s a r i l y t h e same.

The two may be t h e

same i f t h e c e n t r a l bank i s o v e r l y concerned about s h o r t - r u n money market
c o n d i t i o n s o r i f t h e short- run o p e r a t i n g procedure i s n o t constrained by some
long-run objectives.'

We d e f i n e a p o l i c y regime change as a change i n t h e

o b j e c t i v e f u n c t i o n o f t h e pol i c y a u t h o r i t y .

I f the objective function i s a

weighted average o f d i f f e r e n t goals, then t h e p o l i c y change may be a s h i f t i n
t h e r e 1a t i v e weights f o r the d i f f e r e n t goals.

Changes i n o p e r a t i n g procedures

may l e a d t o changes i n the response o f short- term asset p r i c e s t o t h e money

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stock announcements, b u t the response should be short-lived i f there i s no
change i n the objective function.

In t h i s case, there i s not l i k e l y t o be a

response by 1ong-term asset prices.
In October 1979 there was an apparent change in both the monetary policy
regime and the short-run operating procedure.

The Federal Reserve switched

from a pol icy t h a t had led t o accelerating inflation t o a policy t h a t led t o
decelerating i nfl ation.

The Federal Reserve a1 so switched from the federal

funds operating procedure before October 1979 t o the nonborrowed reserve
operating procedure a f t e r October 1979.
operating procedures i n October 1982:

There was a1 so another change in
the Federal Reserve switched from

nonborrowed reserve targeting t o borrowed reserve targeting, which, a s we show
below, i s an interest- rate smoothing procedure.

In t h i s paper we show t h a t

the pattern of asset price reactions t o money stock innovations in the
post-October 1982 period has not returned t o the pattern t h a t prevailed i n the
pre-October 1979 period.

Evidently, market participants be1 ieve the Federal

Reserve has maintained a disinflationary pol icy despite i t s returning t o an
i n t e r e s t - r a t e smoothing procedure.
There was also an institutional change t h a t should have an e f f e c t on how
a s s e t prices respond t o the money stock announcements.

On February 2, 1984,

the Federal Reserve switched reserve accounting rules; the lagged reserve
accounting rul es ( L R R ) t h a t prevai 1ed before February 2, 1984, were rep1 aced
by a1 most contemporaneous reserve accounting rules ( C R R ) . We expl ai n how the
change i n rules has greatly reduced the information content of the money stock
announcements.
In the l i t e r a t u r e review we show t h a t existing hypotheses are inadequate
t o explain the pattern of results t h a t has emerged from past empirical
studies.

In t h i s paper we add a new market, the forward exchange r a t e , and a

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p e r i o d o f new evidence from y e t another change i n o p e r a t i n g procedures.

This

new evidence lends support t o t h e f o l l o w i n g conc1usions:
F i r s t , t h e s t r e n g t h o f t h e r e a c t i o n o f the f e d e r a l funds r a t e and o t h e r
short- term i n t e r e s t r a t e s t o t h e money stock announcements depends on t h e
p r e v a i l i n g o p e r a t i n g procedure and t h e reserve accounting r u l e s .
Second, i n the pre-October 1979 p e r i o d o f an i n f l a t i o n a r y p o l i c y , money
stock s u r p r i s e s contained i n f o r m a t i o n about f u t u r e i n f l a t i o n r a t e s .

Interest

r a t e s and exchange r a t e s reacted t o t h e money stock surprises, because p r i v a t e
agents r e v i s e d t h e i r i n f l a t i o n a r y expectations upward.

Under 1agged reserve

r e q u i rements, s u r p r i s e s i n b11 r e f l e c t e d money demand shocks.

The Federal

Reserve a u t o m a t i c a l l y accommodated these shocks i n t h e s h o r t run.

Over t h e

l o n g run, p o l i c y allowed an upward d r i f t o f t h e monetary t a r g e t s .

This

behavior l e d the market t o b e l i e v e t h a t money stock i n n o v a t i o n s would
e v e n t u a l l y l e a d t o an upward r e v i s i o n o f money t a r g e t s and, consequently,
higher i n f l a t i o n .
T h i r d , i n the post-October 1979 period, the Federal Reserve's monetary
p o l i c y changed t o one o f d i s i n f l a t i o n .

The r a p i d d e c e l e r a t i o n o f i n f l a t i o n

e a r l y i n t h i s p e r i o d has been f o l l o w e d by 1ow and r e l a t i v e l y unchanged
i n f l a t i o n r a t e s i n t h e l a s t two years.

I n t h i s period, t h e r e a c t i o n o f

nominal i n t e r e s t r a t e s and t h e d o l l a r exchange r a t e s t o money stock s u r p r i s e s
r e f l e c t e d changes i n t h e m a r k e t ' s assessment o f c u r r e n t and f u t u r e r e a l
i n t e r e s t rates.

T h i s assessment r e s u l t e d from t h e p e r c e p t i o n t h a t t h e

monetary a u t h o r i t i e s would n o t f u l l y accommodate t h e unusual and p e r s i s t e n t
money demand shocks t h a t occurred d u r i n g t h i s period.

These money demand

shocks o r i g i n a t e d i n p o r t f o l i o disturbances associated w i t h t h e r a p i d decrease
i n i n f l a t i o n , f i n a n c i a l innovations, and deregulation.

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We have organized t h e paper as f o l l o w s :

Section I 1 c o n t a i n s a d i s c u s s i o n

o f t h e i n f o r m a t i o n c o n t e n t o f money stock announcements and a c r i t i c a l review
o f major hypotheses, i n c l u d i n g r e c e n t f i n d i n g s from t h e f o r e i g n exchange
market.

Section I 1 1 s e t s o u t our hypotheses e x p l a i n i n g how asset pt-ices r e a c t

t o money stock announcements under a l t e r n a t i v e p o l i c y regimes and o p e r a t i n g
procedures.

Section I V in c l udes e m p i r i c a l evidence about t h e response o f

short- term i n t e r e s t rates, long- term i n t e r e s t r a t e s , forward i n t e r e s t r a t e s ,
spot exchange rates, and forward exchange r a t e s t o money stock s u r p r i s e s i n
f o u r separate sub- periods between September 1977 and September 1984.

This

s e c t i o n a1so in c l udes concluding comments.

11.

The Issues Surrounding t h e E f f e c t s
o f Money Stock Announcements

The I n f o r m a t i o n Content o f Weekly Announcements
A common e r r o r i n t h e l i t e r a t u r e on t h e e f f e c t o f money stock announce-

ments i s the reference t o them as a supply e f f e c t .

Nichols, Small, and

Webster (1 983) c o r r e c t l y p o i n t o u t t h a t t h e weekly Federal Reserve r e l e a s e o f
t h e M1 data i s an announcement o f t h e p r e l i m i n a r y estimate o f t h e change i n
t h e money stock f o r t h e week ended e i g h t days t o t e n days e a r l i e r .

The

announcement o f the change i n t h e money stock provides new i n f o r m a t i o n about
t h e q u a n t i t y o f money.

I t does n o t d i s t i n g u i s h between demand and supply

shocks, n o r does i t d i s t i n g u i s h between temporary and permanent shocks.
I f t h e weekly M1 growth s e r i e s has a d e t e r m i n i s t i c trend, then weekly

v a r i a t i o n s i n M I should be t h e r e s u l t o f temporary shocks and t h e weekly
announcements should p r o v i d e 1it t l e i n f o r m a t i o n about f u t u r e 1eve1 s o f money
and p r i c e s .

I f so, the observed response o f asset p r i c e s t o money stock

announcements may r e s u l t from market o v e r - r e a c t i on.

Thi s hypothesi s is

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o f f e r e d by S h i l l e r , Campbell, and Schoenholtz (1983).

I f t h e weekly M I growth

s e r i e s has a s t o c h a s t i c trend, then weekly v a r i a t i o n s i n M1 c o u l d be t h e
r e s u l t o f permanent shocks, and t h e weekly announcements c o u l d c o n t a i n u s e f u l
i n f o r m a t i o n about f u t u r e l e v e l s o f money and p r i c e s .

I n t h i s case, t h e market

r e a c t i o n i s appropriate.
We use Nelson and P l o s s e r ' s (1982) method t o t e s t whether a s e r i e s has a
d e t e r m i n i s t i c o r a s t o c h a s t i c trend.
s e r i e s a r e shown below.

Two models o f t h e weekly money stock

The f i r s t i s a model w i t h a d e t e r m i n i s t i c t r e n d :

The second i s a model w i t h a s t o c h a s t i c trend:

I n each case,

7' and 0 s a t i s f y c o n d i t i o n s

f o r s t a t i o n a r i t y and i n v e r t i b i l i t y .

I n model 2 the s u r p r i s e i n t h e money stock announcement w i l l be a t r a n s i t o r y
random e r r o r , l i k e l y t o be o f f s e t i n f u t u r e d e v i a t i o n s o f money from trend.
I n model 3 a s u r p r i s e i n M I i s permanently i n c o r p o r a t e d i n t h e 1eve1 o f M I .
The Federal Reserve's p o l i c y o f rebasing t a r g e t s a t t h e end o f each t a r g e t i n g
p e r i o d 1ends credence t o t h e second model

.

I f model 2 i s accurate, then weekly v a r i a t i o n s i n M I should have l i t t l e
i n f o r m a t i o n about f u t u r e l e v e l s o f money and p r i c e s .

Federal Reserve

o f f i c i a l s have maintained f o r some time t h a t such i s t h e case.

In a letter to

Senators Jake Garn and W i l l i a m Proxmire, Federal Reserve Chairman Paul Volcker
( 1981 ) wrote:
There i s n e a r l y unanimous agreement by a l l observers t h a t weekly
money s t a t i s t i c s a r e extremely e r r a t i c , and t h e r e f o r e , poor
i n d i c a t o r s o f u n d e r l y i n g trends. Whi 1e monthly data can o f t e n
d e v i a t e considerably from such trends, t h e weekly observations a r e
p a r t i c u l a r l y " noisy." Week-to-week changes a r e q u i t e l a r g e and

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recent estimates indicate t h a t the "noise" element--attributable t o
the random nature of money flows and d i f f i c u l t i e s i n seasonal
adjustment--accounts f o r plus or m i n u s $ 3 . 3 billion i n weekly change
two-thirds of the time. Such a large e r r a t i c element appears
i n t r i n s i c t o money behavior, rather than implying poor underlying
statistics.
This interpretation of the "noise" i n MI data suggests t h a t weekly MI
announcements contain 1i t t l e information about future 1eve1s of the money
stock or prices.

T h i s interpretation implies t h a t there i s a deterministic

trend in the money supply.

If so, the variance of forecast errors a t period

t + n i s bounded f o r a l l n.
If model 3 i s accurate, the variance of the forecast e r r o r i s unbounded as

n3-,

and the l a t e s t change in itll may be an important b i t of information i n

forming predictions about long-run level s of MI.

The market will use a1 1 of

the information i t has t o make 1ong-term forecasts of MI.

When the long-run

objectives of policy are unclear, the weekly s t a t i s t i c s become more
The Federal Reserve can make the weekly s t a t i s t i c s l e s s relevant

important.

by announcing and foll owing credible long-run pol icies.
The t e s t i s calculated from the following regression:

where
m

=

natural log of MI,

A = constant,

t

=

time, and

e

=

random error.

Here k i s large enough to remove tile systematic component from the error
term.

The t e s t i s based on the assumption t h a t only autoregressive terms a r e

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needed to obtain satisfactory representations of the e r r o r term.

Nelson and

Plosser (1982) show that the t e s t of whether a time series has a deterministic
or a stochastic trend can be reduced t o a t e s t of whether the autoregressive
process generating the time s e r i e s has a root equal t o unity.

They show

that f 1 of equation 4 i s equal to the sum of the autoregressive parameters,
the (Pi.

Under the null hypothesis t h a t the time series has a stochastic

trend, this sum will equal unity.

The r e s u l t s of t h i s estimation, shown i n

tab1 e 1, support the hypothesis that the weekly M1 data are generated by model
3.

The relevant s t a t i s t i c for our purposes i s 7 , which i s the t - s t a t i s t i c

for the hypothesis that

P1 = 1.

Fuller (1976) shows the distribution of

under the hypothesis t h a t f1 = 1.

Z

For the sample size of 100, the 0.05

c r i t i c a l value i s -3.45; f o r a sample size of 250, the 0.05 c r i t i c a l value i s
-3.43.

Dickey and Fuller (1 979) provide Monte Carlo evidence on the power of

the t e s t .
Using both the expected and the first- published data on MI, we cannot
r e j e c t the hypothesi s that the autoregressive processes generating the data
contain a root equal to unity.

These r e s u l t s are consistent with the

hypothesis t h a t the weekly money stock data contain important information
about future levels of MI.

Of course, whether the announcements contain

information about future prices depends on whether the stochastic trend i s
caused by non-stationarity in the nominal money supply or i n the real money
demand function.
be1 ow.

An examination of t h i s issue i s provided i n the discussion

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Table 1

T e s t i n g f o r an Autoregressive Root Equal t o U n i t y i n t h e Stochastic
Process Generating Weekly Money Stock Data

Pre-October 1979

Jan 5, 1978

-

Post-October 1979

Oct 4,1979

Feb 8, 1980

-

Sept 20, 1984

mt

l o g (Mia)

l o g (Mle)

l o g (Mla)

l o g (Mle)

SEE

0.00554

0.00377

0.0051 8

0.00425

Notes: The t - s t a t i s t i c s a r e shown i n parentheses. Mla i s t h e f i r s t
pub1i s h e d f i g u r e f o r MI. Mle i s t h e sum o f t h e previous p e r i o d Mla and
t h e change p r e d i c t e d by t h e p a r t i c i p a n t s i n Money Market Services weekly
survey. The second sample p e r i o d begins i n February 1980, a f t e r t h e change i n
t h e d e f i n i t i o n o f M I . I n no case can we r e j e c t t h e hypothesis t h a t
f 1 = 1. The 0.05 c r i t i c a l value f o r % i s -3.43 f o r sample s i z e s o f 100.

C r i t i c a l Review o f t h e L i t e r a t u r e
Extensive research on t h e t o p i c o f t h e money supply announcements over t h e
l a s t f i v e years has l e d t o a predominance o f f o u r main hypotheses.

The f i r s t

h y p o t h e s i s asserts t h a t a s u r p r i s e i n t h e money stock announcement c o n t a i n s

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i n f o r m a t i o n about f u t u r e money supply growth.

Cornel 1 ( 1 983a) c a l l s i t t h e

expected i n f l a t i o n hypothesis, i n which a p o s i t i v e money stock s u r p r i s e w i l l
be i n c o r p o r a t e d i n f u t u r e l e v e l s o f t h e money supply.

As a r e s u l t , i n t e r e s t

r a t e s r i s e t o r e f l e c t an i n f l a t i o n premium, and t h e d o l l a r depreciates a g a i n s t
major f o r e i g n currencies.

However, the spot exchange r a t e does n o t depreciate

i n t h e pre-October 1979 p e r i o d as t h i s hypothesis p r e d i c t s .

Furthermore, t h e

spot value o f the d o l l a r appreciates f o l l o w i n g t h e money stock announcement i n
t h e post-October 1979 period.

Also, t h i s hypothesis does n o t e x p l a i n why

long- term i n t e r e s t r a t e s and forward i n t e r e s t r a t e s r e a c t more s t r o n g l y i n t h e
post- October 1979 p e r i o d than i n t h e pre-October 1979 period.

To e x p l a i n t h e

s t r o n g e r r e a c t i o n o f long- term r a t e s i n t h e l a t e r period, advocates o f t h e
expected i n f l a t i o n hypothesis have t o assume t h a t t h e October 6, 1979, change
i n t h e o p e r a t i n g procedure 1ed t c a decl ine i n t h e Federal Reserve ' s concern
about i n f l a t i o n .
The secbnd hypothesis assumes t h a t money stock s u r p r i s e s c o n t a i n
i n f o r m a t i o n about money demand shocks.
hypothesis.

This i s c a l l e d t h e p o l i c y a n t i c i p a t i o n

Works by U r i c h and Wachtel (1981 ), U r i c h (1982), and Roley and

Walsh (1983) a r e based on t h e assumptions t h a t p r i c e s a r e f i x e d and t h a t t h e
Federal Reserve uses a p a r t i a l adjustment procedure t o achieve i t s monetary
targets.

The p u b l i c expects d e v i a t i o n s o f t h e money stock from t h e

preannounced t a r g e t s t o be o f f s e t gradually.

Under nonborrowed reserve

t a r g e t i n g , an exogenous demand shock w i l l a u t o m a t i c a l l y f o r c e more banks t o go
t o t h e discount window.

T h i s shock w i l l be completely o f f s e t i f t h e Federal

Reserve maintains i t s nonborrowed reserve t a r g e t .

Under t a r g e t i n g o f t h e

f e d e r a l funds r a t e , the shocks i n i t i a l l y w i l l be accommodated b u t c o u l d be
o f f s e t e v e n t u a l l y i f t h e Federal Reserve were w i l l i n g t o a d j u s t t h e f e d e r a l
funds r a t e t a r g e t promptly.

Therefore, given p r i c e r i g i d i t y , a p o s i t i v e money

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stock surprise would generate anticipation of future tightening of money
growth, which would r a i s e short-term real i n t e r e s t r a t e s via the liquidity
e f f e c t and long-term real i n t e r e s t rates via the expectations theory of the
term structure.

The change i n real i n t e r e s t rates would induce international

capital flows t h a t would r e s u l t in a do1 l a r appreciation.3 The duration and
strength of the policy anticipation e f f e c t would depend on how long i t takes
the Federal Reserve to o f f s e t past deviations from the target and the degree
of price rigidity.
This hypothesis i s not consistent w i t h the empirical evidence.
inconsistency l i e s in the reaction of the forward i n t e r e s t rates.

The
Shiller,

Campbell , and Schoenhol t z (1983) and Hardouvel i s (1984) have shown t h a t
longer-term forward i n t e r e s t rates react strongly t o money stock
announcements.

The pol icy anticipation hypothesis expl ains the r e s u l t only i f

the liquidity e f f e c t l a s t s f o r several years.
The third hypothesis i s a synthesis of the f i r s t two.

Hardouvel i s (1984)

and Loeys (1984) argue thax the liquidity e f f e c t dominates i n the short r u n
and the inflation premium e f f e c t dominates i n the long r u n .

Following a

positive surprise in the money stock, short-term nominal i n t e r e s t rates r i s e
because the market expects the Federal Reserve to o f f s e t p a r t i a l l y the
deviations above the money supply target.

However, because the Federal

Reserve i s not expected t o o f f s e t the money stock surprise completely,
inflationary expectations and long-term i n t e r e s t rates r i s e .

In addition,

Hardouvelis shows t h a t the reactions of the spot exchange rates and the
expected spot exchange rates five years ahead, which are derived from an open
i n t e r e s t rate parity condition, support his hypothesis.

The spot values of

the dollar against several foreign currencies appreciate, and the expected
future spot rates depreciate.

However, the expected future spot rates a r e

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constructed on the implicit assumption t h a t real i n t e r e s t r a t e s a r e fixed.
These r e s u l t s cannot be used t o distinguish between the policy anticipation
and the inflation premi urn hypotheses, because the inflation premium hypothesis
was implicitly assumed i n the construction of the expected spot exchange rate.
There i s another drawback i n t h i s third hypothesis.

Cornell ( 1 983b, p.

655) points out t h a t " i t i s i n t u i t i v e l y d i f f i c u l t t o understand how the same

announcement leads agents to expect monetary r e s t r i c t i o n i n the short run, b u t
monetary ease i n the long run."

The Hardouvelis argument t h a t the significant

response of long forward rates i n the post-October 1979 period r e f l e c t s an
inflation premium i s not satisfactory.

The period before October 1979 was

more inflationary, y e t empirical evidence indicates a weak reaction of forward
i n t e r e s t rates to money stock announcements during the period.
Hardouvel i s hypothesi s i s not consistent w i t h t h i s evidence.

The
Furthermore,

there i s no economic theory t o explain why the spot and expected spot exchange
rates would move i n opposite directions following a surprise i n the money
stock announcement.

The explanation given by Hardouvelis i s plausible.

However, t h i s explanation i s based on an arbitrary expectation of a future
reversal of pol icy, which i s not refutable.
The fourth hypothesis, outlined by Nichols, Small, and Webster, i s called
the real a c t i v i t y hypothesis.4 They argue t h a t i f prices are fixed and the
Federal Reserve pursues a policy of constant money growth, money stock
surprises provide information about current and future real money demand
growth t h a t results from real- sector disturbances.

A positive money stock

surprise signals t o the market participants stronger current and future money
demand growth relative to the given money supply growth.

As a result, current

and expected future real i n t e r e s t rates r i s e to c l e a r the money market.

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On t h e e m p i r i c a l l e v e l , t h e hypothesis s u f f e r s because M1 growth was
s t r o n g i n 1a t e 1981 , 1982, and e a r l y 1983 whi 1e r e a l a c t i v i t y was s u r p r i s i n g l y
weak; y e t , t h i s was the p e r i o d when t h e r e l a t i o n s h i p between money stock
s u r p r i s e s and i n t e r e s t r a t e s was strongest.

Furthermore, t h i s hypothesis

cannot e x p l a i n why i n t e r e s t r a t e s respond t o money stock s u r p r i s e s i n t h e
pre-October 1979 p e r i o d when t h e Federal Reserve was accommodating money
demand shocks.

On t h e a n a l y t i c a l l e v e l , t h e assumption o f p r i c e r i g i d i t y i s

n o t necessary t o e x p l a i n why t h e s u r p r i s e i n t h e money stock announcement
leads t o changes i n expected r e a l i n t e r e s t r a t e s .

Evidence from t h e Foreign Exchange Market
Since t h e evidence o f t h e r e a c t i o n o f i n t e r e s t r a t e s t o t h e money stock
announcements was i n s u f f i c i e n t t o d i s t i n g u i s h between competing hypotheses,
researchers were encouraged t o 1ook a t a c r o s s s e c t i o n o f markets.

Engel and

Frankel (1984) use evidence from t h e s p o t market f o r exchange r a t e s t o
d i s t i n g u i s h between the expected i n f l a t i o n hypothesis and the p o l i c y
a n t i c i p a t i o n hypothesis.

This subsection shows t h a t t h e assumption o f p r i c e

r i g i d i t y i n t r o d u c e d by Engel and Frankel i s n o t necessary t o e x p l a i n t h e
a p p r e c i a t i o n o f the d o l l a r f o l l o w i n g a p o s i t i v e money stock s u r p r i s e .

Also,

t h e i n f o r m a t i o n provided by the spot exchange r a t e i s incomplete and, under
c e r t a i n c o n d i t i o n s , may be m i s l eadi ng.
A f u l l y devel oped v e r s i o n o f t h e Engel -Frankel model in c l udes :

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where
mt and pt = l o g s o f t h e money supply and t h e p r i c e l e v e l ,

it= s h o r t - t e r m i n t e r e s t r a t e ,
= i n f l u e n c e o f r e a l income and o t h e r exogenous s h i f t s i n money demand,

at

rt = r e a l i n t e r e s t r a t e ,
= expected v a r i a b l e , and

*

= f o r e i g n country v a r i a b l e .

Equation 5 i s a Cagan-type money demand equation.

Equations 6 and 7 show t h e

F i s h e r r e l a t i o n s h i p s f o r t h e home c o u n t r y and t h e f o r e i g n country.
i n f l a t i o n i s represented by

--

*

e
pt+l

*

pt.

Expected

e*
Normalizing so t h a t pt+l

pt = 0, and assuming t h a t rt = rt, we o b t a i n t h e f o l l o w i n g

expression from equations 5 through 7:

(8)

mt

-

pt =

-A

*
e
( P ~ +- ~pt + i t ) + at.

S o l v i n g 5 f o r pt through the method of r e c u r s i v e s u b s t i t u t i o n , we o b t a i n t h e
f o l l owing expression:

Assume t h a t a p o s i t i v e money stock announcement i n p e r i o d t leads t h e market
t o r e v i s e upward i t s expectations concerning c u r r e n t and f u t u r e money demand
changes.

I f t h e Federal Reserve i s f o l l o w i n g a c r e d i b l e pol i c y o f p r i c e

s t a b i 1 it y , t h e announcement w i 11 n o t a f f e c t the market' s expectations w i t h
I

r e g a r d t o f u t u r e money supply changes.
equal t o :

The new p r i c e l e v e l ( p t )

w i l l be

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Subtracting equation 9 from equation 10 yields equation 11 :

I

Because Etat+j i s greater than Etat+j f o r every value of t, the

- pt difference i s negative; i . e . , the price level will f a l l . Note
t
t h a t i f the exchange rate i s determined by purchasing power parity, the
exchange rate equation can be written i n log form as follows:

The reduction i n the domestic price level will lead t o a d o l l a r appreciation,

*

given t h a t pt remains unchanged.

Similarly, i t can be shown t h a t the

future price level, pt+l, will fa1 1.

If the forward exchange r a t e i s an

unbiased predictor of the future spot rate, and i f the l a t t e r i s determined by
the price level differential in period t + l , the forward exchange rate will
appreciate.
Wal sh (1984) argues that the change in operating procedures in 1979 caused
a change i n the parameters of the money demand function.

Whether due t o the

inflation policy change or the operating procedure change, there appears t o
have been an increase in the i n t e r e s t e l a s t i c i t y of money demand sometime
a f t e r October 1979.

I f there was an increase i n 2 , the change in the

price level shown in equation 11 would be larger following a surprise increase

In sum, i t has been shown t h a t i f a money stock surprise signals a
persistent money demand shock originating i n a portfolio disturbance and i f
the Federal Reserve i s following a fixed money growth rule, the spot and
forward exchange rates will appreciate.
r i g i d i t y to obtain t h i s result.

There i s no need t o assume price

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Furthermore, s t u d i e s t h a t examine t h e r e a c t i o n o f s p o t exchange r a t e s t o
money stock announcements i g n o r e t h e e f f e c t s o f f o r e i g n exchange i n t e r v e n t i o n
by monetary a u t h o r i t i e s t h e day a f t e r t h e money stock announcement.

To

i l l u s t r a t e t h i s p o i n t , assume t h a t t h e monetary a u t h o r i t i e s i n t e r v e n e based on
t h e f o l 1owing r u l es :

where
It= amount o f d o l l a r i n t e r v e n t i o n by t h e U n i t e d States t h e day

a f t e r t h e announcement,
MtS = money stock s u r p r i s e , and
= amount o f d o l l a r i n t e r v e n t i o n by West Germany t h e day

a f t e r t h e announcement.
Although t h e exchange r a t e and i n t e r v e n t i o n are interdependent, f o r t h e sake
o f simp1 i c i t y we can w r i t e t h e f o l l o w i n g equation:

where
e

t

= exchange r a t e on t h e day f o l l o w i n g the announcement, and

Zt = o t h e r r e l e v a n t v a r i a b l e s on the day f o l l o w i n g t h e

announcement.
Equation 15 s t a t e s t h a t on t h e day f o l l o w i n g the announcement t h e exchange
r a t e w i l l be determined by domestic and f o r e i g n i n t e r v e n t i o n and a l l o t h e r
re1evant f a c t o r s represented by t h e v e c t o r Z.
The observed r e l a t i o n s h i p between a p o s i t i v e money stock s u r p r i s e and an
a p p r e c i a t i n g d o l l a r may be spurious.

I f t h e Federal Reserve expects t h e

d o l l a r t o depreciate sharply f o l l o w i n g a p o s i t i v e money stock surprise, i t may
purchase d o l l a r s h e a v i l y t h e n e x t day--perhaps j o i n t l y w i t h t h e West German

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authorities.

I f so, t h e a p p r e c i a t i o n o f t h e d o l l a r was n o t caused by t h e

announcement e f f e c t b u t by i n t e r v e n t i o n ; the Engel and Frankel and t h e
Hardouvel i s i n t e r p r e t a t i o n s thus may be i n c o r r e c t .
T e s t i n g f o r t h e s i g n i f i c a n c e o f t h i s hypothesis i s extremely d i f f i c u l t
because o f s i m u l t a n e i t y problems.

However, f o r t h e Engel and Frankel sample

p e r i o d (October 1979 t o August 1981 1, t h e c o r r e l a t i o n c o e f f i c i e n t between t h e
money stock s u r p r i s e and U.S.
r e l a t i v e l y small.

i n t e r v e n t i o n on t h e f o l l o w i n g day i s -0.106,

The negative s i g n i m p l i e s t h a t f o l l o w i n g a p o s i t i v e money

stock surprise, t h e U n i t e d States s o l d d o l l a r s , which would moderate t h e
d o l l a r appreciation.

T h i s i s c o n s i s t e n t w i t h t h e n o t i o n t h a t c e n t r a l banks

" l e a n a g a i n s t t h e wind" i n t h e i r i n t e r v e n t i o n pol i c y , and i t makes t h e Engel
and Frankel f i n d i n g s mot-e c r e d i b l e .

The U n i t e d S t a t e s has p r a c t i c a l l y ceased

i n t e r v e n t i o n i n t h e f o r e i g n exchange markets under t h e Reagan a d m i n i s t r a t i o n .
However, t h e West German and o t h e r European monetary a u t h o r i t i e s have
continued i n t e r v e n i n g r e g u l a r l y , which s t i l l r a i s e s some questions about t h e
i n t e r p r e t a t i o n o f r e s u l t s from t h e spot r e a c t i o n o f t h e spot exchange r a t e t o
money stock announcements.
F i n a l l y , researchers have ignored the i n f o r m a t i o n contained i n t h e changes
o f t h e forward exchange r a t e .

The advantages of examining t h e r e a c t i o n o f

forward exchange r a t e s a r e twofold:

changes i n t h e forward exchange r a t e s

f o l l o w i n g a money stock s u r p r i s e a r e f r e e o f t h e i n f l u e n c e o f i n t e r v e n t i o n ,
and t h e examination o f t h e simultaneous r e a c t i o n o f t h e spot and forward
exchange r a t e s provides useful i n f o r m a t i o n as t o t h e nature and p e r s i s t e n c e o f
a shock.

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111.

The Role of Policy Regimes and Operating Procedures

The empirical studies cited above do not distinguish clearly between the
different policy regimes and the various operating procedures t h a t may be used
t o achieve the d i f f e r e n t policies.
to make the distinction.

In theory, there i s l i t t l e a priori reason

If a regime were defined i n terms of a pol icy

objective function and a structural model, then any change i n the objective
function or i n the structure, including a change i n the short-run pol icy
reaction function, would lead t o a change in the reduced-form equations f o r
asset prices.

In practice, changes in very short-run operating procedures may

have l i t t l e e f f e c t on asset prices i f the objective function and other
structural parameters remain fixed.

Many different operating procedures could

be used to achieve the same objectives; or, one operating procedure could be
used t o achieve very different objectives.

O u r hypothesis i s that the Federal

Reserve emphasized non-price objectives before October 1979.

During thi s

period the Federal Reserve used an i n t e r e s t - r a t e targeting procedure t o
achieve the monetary targets.

After October 1979 the Federal Reserve p u t more

emphasis on ending inflation and adopted a policy t h a t led t o decelerating
inflation.

A t the same time the Federal Reserve switched t o a nonborrowed

reserve operating procedure i n which i t t r i e d t o control the money supply by
controlling nonborrowed reserves directly and by applying administrative
pressure a t the discount window.
The nonborrowed reserve procedure was o f f i c i a l l y abandoned i n October
1982.

Since t h a t time, the Federal Reserve has used a borrowed reserve

targeting procedure.

I t i s shown below that a borrowed reserve procedure may

be described as an interest- rate smoothing procedure.

However, the return to

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-

19

-

an i n t e r e s t - r a t e smoothing procedure does not necessarily mean t h a t the
Federal Reserve has returned t o an i nfl a t i onary pol icy regime.

The Pol icy Regime
The pol icy regime, defined i n t h i s study by the objectives of policy,
should have an important e f f e c t on the pattern of responses by a s s e t prices to
In the pre-October 1979 period,

a surprise in the money stock announcement.

the surprises i n the money stock mainly reflected money demand shocks t h a t on
average carried M1 t o or above the upper l i m i t of the target range.

Instead

of offsetting these deviations from the monetary target, the Federal Reserve
a1 lowed the monetary targets t o d r i f t upward.

This pol icy 1ed the market to

be1 ieve that a positive money stock surprise would lead to a s h i f t i n the
money supply function, regardless of the origin of the shock.

A positive

money stock surprise was an indication of future inflation; one expected
i n t e r e s t rates to r i s e and the dollar t o depreciate in response to a higher
i n f l a t i o n premium.
In the post-October 1979 period, the Federal Reserve announced t h a t i t was
placing more emphasis on ending inflation.
operating procedures.

The Federal Reserve a1 so switched

The nonborrowed reserve procedure allowed the Federal

Reserve a method of inducing large interest- rate changes i n response t o
deviations of money from target.

Under t h i s procedure, the Federal Reserve

was able to reverse deviations of M1 from the target path more quickly.

Thus,

the change in procedures l e n t credi bil i ty to the Federal Reserve's
announcement that i t had switched t o a policy of disinflation.
After 1980, the actual inflation rate began t o f a l l more quickly than
expected.

Inflation expectations were lowered, and there was a large increase

in the demand for money.

In the classical model ,-a one-time 1owering of the

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i n f l a t i o n r a t e r e q u i r e s a one- time d e c l i n e i n t h e p r i c e l e v e l - - o r a
compensating increase i n t h e nominal money supply- - to c l e a r t h e market f o r
r e a l balances.

I n t h i s p e r i o d t h e r e was a r a p i d d e c l i n e o f i n f l a t i o n below

t h e r a t e t h a t was thought t o be c o n s i s t e n t w i t h t h e Federal Reserve's monetary
t a r g e t s , and t h e r e was a l a r g e p o s i t i v e d r i f t i n M I above t h e t a r g e t s i n both
1982 and 1983.
T h i s one-time s h i f t i n t h e demand f o r r e a l balances described above i s a
temporary phenomenon.

Mundel 1 ( 1 963

and Tobin (1 965) argue t h a t a r e d u c t i o n

i n t h e e q u i l i b r i u m i n f l a t i o n r a t e can a1 so r a i s e t h e t r e n d i n t h e growth r a t e
o f money demand; t h i s r e s u l t s from a wealth e f f e c t . 6

A t a lower expected

i n f l a t i o n r a t e , t h e h i g h e r demand f o r t h e r e a l balances w i l l l e a d t o a
l e f t w a r d s h i f t i n t h e demand f o r r e a l savings and t o an increase i n t h e .real
i n t e r e s t rate.
D u r i n g t h i s p e r i o d t h e r e was another i m p o r t a n t f a c t o r t h a t should have l e d
t o an i n c r e a s e i n t h e demand f o r money--the end o f t h e p r o h i b i t i o n a g a i n s t
e x p l i c i t i n t e r e s t - r a t e payments on checkable deposits i n January 1981.

This

change a l s o was expected t o have b o t h temporary and permanent e f f e c t s on t h e
growth o f t h e demand f o r M I .

When d e p o s i t o r y i n s t i t u t i o n s were allowed t o pay

i n t e r e s t on checkable accounts, t h e r e should have been a one-time s h i f t o f
funds o u t o f passbook savings and o t h e r sources o f wealth i n t o M I .

This l a r g e

t r a n s i t o r y s h i f t o f funds was expected t o be f o l l o w e d by a permanent increase
i n t h e growth r a t e o f t h e demand f o r M I , r e s u l t i n g from the permanent
r e d u c t i on i n the o p p o r t u n i t y c o s t o f h o l d i n g checkable deposits.

7

In sum, these changes c o u l d have been expected t o increase t h e demand f o r
r e a l balances.

As l o n g as t h e Federal Reserve was expected t o m a i n t a i n i t s

d i s i n f l a t i o n o b j e c t i v e , i t was n o t expected t o accommodate f u l l y f u t u r e
i n c r e a s e s i n money demand.

Therefore,

a p o s i t i v e money stock s u r p r i s e was

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seen as a r e l a t i v e increase i n money demand, l e a d i n g t o an increase i n t h e
real i n t e r e s t rate.

I f t h i s hypothesis i s c o r r e c t , then i n t h e post-1979

p e r i o d we expect an increase i n b o t h s h o r t - and long- term i n t e r e s t r a t e s and a
s i g n i f i c a n t a p p r e c i a t i o n i n b o t h spot and forward exchanges f o l l o w i n g a
s u r p r i s e increase i n t h e money stock.

The Operating Procedure
Monetary p o l i c y a c t i o n s in f l uence market v a r i a b l e s d i r e c t l y through t h e i r
e f f e c t on t h e reserve market and i n d i r e c t l y through t h e i r e f f e c t on
expectations.

We have examined t h e i n d i r e c t e f f e c t .

T h i s subsection

describes t h e d i r e c t e f f e c t by a n a l y z i n g a t y p i c a l bank's use o f i n f o r m a t i o n
i n t h e money stock announcement under a l t e r n a t i v e reserve accounting r u l e s and
o p e r a t i n g procedures.

Between September 1968 and February 1984, banks were

.

r e q u i r e d t o h o l d reserves a g a i n s t d e p o s i t s on a 1agged b a s i s ; i e.,

average

d a i l y reserves h e l d i n any g i v e n week were used t o meet reserve requirements
c a l c u l a t e d from d e p o s i t l e v e l s o f two weeks e a r l i e r .

T h i s 1ag was i n s t i t u t e d

i n 1968 t o g i v e i n d i v i d u a l banks p r e c i s e knowledge about t h e l e v e l o f t h e i r
reserve requirement.

The l a g a l s o gave t h e Federal Reserve time t o c o l l e c t

i n f o r m a t i o n about aggregate reserve demand.
I n February 1984, t h e Federal Reserve implemented a r e t u r n t o almost
contemporaneous reserve accounting.

The banking system had objected t o t h i s

s w i t c h on the grounds t h a t i t would be c o s t l y t o s e t up t h e i n f o r m a t i o n
systems necessary t o m o n i t o r d e p o s i t l e v e l s on an instantaneous basis.

As a

concession t o t h i s issue, t h e Federal Reserve chose a form o f CRR t h a t was n o t
t r u l y contemporaneous; instead, t h e l a g was reduced from f o u r t e e n days t o two
days.

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The new r u l e s i n c l u d e d o t h e r changes.

One was a l e n g t h e n i n g o f t h e

reserve accounting p e r i o d from one week t o two weeks.

Banks now p o s t reserves

averaged over two weeks ending on a Wednesday, a g a i n s t d e p o s i t s averaged over
two weeks ending on a Monday.

Banks have two days t o measure t r a n s a c t i o n s

deposits and a d j u s t t h e i r reserve p o s i t i o n s accordingly.

Only reserve

requirements a g a i n s t t r a n s a c t i o n s d e p o s i t s a r e contemporaneous.
There was a l s o a change i n t h e t i m i n g o f t h e weekly money stock
announcement.
EST.

The announcement was moved up one day t o Thursday, 4:30 prn

Even though t h e Federal Reserve r e q u i r e d banks t o speed up t h e

c o l l e c t i o n and r e p o r t i n g o f d e p o s i t data, the a c t u a l data released on Thursday
a r e " o l d e r " than data t h a t had been released on Friday.

Under t h e lagged

reserve accounting r u l e s , t h e weekly money stock data re1eased on F r i d a y
r e f e r r e d t o t h e average d a i l y l e v e l o f M1 f o r t h e week ending on Wednesday,
n i n e days e a r l i e r .

Under t h e new arrangement, t h e data released on Thursday

r e f e r t o t h e average d a i l y l e v e l o f M1 f o r t h e week ending Monday, t e n days
e a r lie r .
On t h e l a s t day (Wednesday) o f the weekly s e t t l e m e n t period, a l l banks
have t o meet t h e i r reserve requirements.

This i s an unusual market; we can

t h i n k o f no o t h e r where a l l fir-rns a r e r e q u i r e d t o a d j u s t i n v e n t o r i e s t o
p r e - s p e c i f i e d l e v e l s a t t h e same time.

E a r l y i n t h e reserve accounting

period, b e f o r e t h e money supply announcernent, each bank coul d c a l c u l a t e i t s
own reserve requirement, b u t i t d i d n o t know aggregate reserve demand.

Under

lagged reserve accounting r u l e s , t h e announcement o f M I was made nine days
a f t e r t h e end o f t h e d e p o s i t computation period, b u t f i v e days before t h e end
o f t h e reserve maintenance period.

Consequently, t h e money stock announcement

contained i n f o r m a t i o n about t h e aggregate demand f o r reserves i n the

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settlement p e r i o d ending f i v e days hence.

Under contemporaneous reserve

accounting r u l e s , t h e announcement o f M1 i s always made a f t e r t h e reserve
market c l e a r s .
To e x p l a i n t h e r e a c t i o n o f t h e f e d e r a l funds r a t e t o t h e money stock
announcement, we w i l l l o o k a t t h r e e f a c t o r s : t h e reserve accounting r u l e s , t h e
nonborrowed reserve o p e r a t i n g procedures, and t h e t i m i n g o f t h e r e l e a s e of
i n f o r m a t i o n about t h e money stock.

Under t h e f e d e r a l funds r a t e t a r g e t i n g

procedure and lagged reserve accounting, t h e market had q u i t e good i n f o r m a t i o n
about the reserve supply f u n c t i o n .

The Federal Open Market Committee (FOMC)

s e t narrow 1i m i t s w i t h i n which t h e federal funds r a t e was allowed t o
fluctuate.

The manager o f t h e open market desk a t the Federal Reserve Bank o f

Mew York ( h e r e a f t e r r e f e r r e d t o as the desk) would e n t e r t h e market t o s e l l
s e c u r i t i e s i f t h e f e d e r a l funds r a t e f e l l below t h e lower 1i m i t; he would
e n t e r t h e market t o buy s e c u r i t i e s whenever t h e f e d e r a l funds r a t e traded
above t h e upper l i m i t .

This i n t e r v e n t i o n throughout t h e t r a d i n g day sent an

immediate s i g n a l t o t h e market about t h e l i m i t s on t h e o p e r a t i n g t a r g e t .

The

FOMC d i r e c t e d t h e desk t o s e t a narrow range f o r t h e f e d e r a l funds r a t e , b u t
t h e range was c o n d i t i o n e d on o b j e c t i v e s o f t h e FOMC, u s u a l l y on t h e growth o f
t h e monetary aggregates r e l a t i v e t o s h o r t - r u n paths t h a t were s e t a t t h e FOMC
meetings.

However, changes i n t h e l i m i t s f o r t h e federal funds r a t e range

were small and i n f r e q u e n t .

As a r e s u l t o f t h i s procedure, t h e market n o t

o n l y knew t h e c u r r e n t t a r g e t , b u t a l s o i t c o u l d f o r e c a s t short- term i n t e r e s t
r a t e s several weeks i n advance w i t h small e r r o r s .

The weekly money stock

announcement was important i n p r e d i c t i n g t h e reserve supply f u n c t i o n o n l y i n
so f a r as t h e f e d e r a l funds r a t e l i m i t s were expected t o be changed i n
response t o a d e v i a t i o n o f t h e money stock from the d e s i r e d path.

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The reserve market i s shown in panel a of figure 1.

The reserve supply

function R; represents the end-of-period position of the reserve supply
curve expected by market participants before the money supply announcement.
Likewise, RBd represents the reserve demand function before the money
stock announcement. The reserve supply function i s i n f i n i t e l y e l a s t i c
reflecting the f a c t t h a t the Federal Reserve accommodated short-run changes i n
the demand f o r reserves.

The reserve demand curve i s i n e l a s t i c because of

1agged reserve requirements.
announcement i s FF*.

The actual federal funds rate target before the

I t i s also the rate t h a t i s expected to prevail through

the end of the reserve maintenance period.
Suppose there i s a large unexpected increase i n b41 t h a t s h i f t s the
expected end-of-period reserve demand curve t o the right.

Early i n the next

trading day, the market would learn whether t h i s increase were enough t o
induce the desk t o s h i f t the reserve supply curve.

If the desk intervened to

prevent a r i s e i n i n t e r e s t rates, the quantity of reserves supplied would r i s e
t o accommodate the increase i n demand.

Because the public expected the

Federal Reserve to accommodate unexpected s h i f t s i n money demand, the federal
funds r a t e would be unchanged.

However, we m i g h t expect longer-term i n t e r e s t

rates t o r i s e i f the market participants expected t h i s increase i n supply t o
lead t o inflation, or i f they expected the Federal Reserve t o raise the
i n t e r e s t - r a t e operating range i n future weeks.

During t h i s period the

importance of the money stock announcement was limited by the
information-transmitting aspects of the interest- rate operating procedure.
When the FOMC announced a change i n operating targets on October 6, 1979,
there was a dramatic change i n the information flow to the market about the
r e l a t i v e position of the reserve supply function.

Following an FOMC meeting,

the Federal Reserve s t a f f of economists constructed paths f o r nonborrowed

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Panel a :

F e d e r a l funds R a t e T a r g e t ( f F ' )

Panel b:

t:onborroued Reserves T a r g e t (NBR')

Panel c :

Borroved Reserves T a r g e t

F isure 1

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reserves based on a short-run path f o r MI and an i n i t i a l borrowing
assumption.

The procedure was t o maintain the path f o r nonborrowed reserves

and allow unexpected changes i n total reserve demand to feed into the discount
window.

The nonborrowed reserve path was adjusted automatically i n response

t o unexpected changes i n the multiplier.

Sometimes, though not often, the

nonborrowed reserve path was adjusted judgmentally for policy reasons, such as
the behavior of the broader aggregates or some other economic variable. 8
The reserve supply function i s shown i n panel b of figure 1.

Market

participants estimated expected nonborrowed reserve targets (NBR*) using
information about the annual monetary targets, minutes from past FOFIC
meetings, and recent information about MI.

Neither market participants nor

the Federal Reserve had accurate information about the demand f o r borrowed
reserves.

Federal Reserve administrative guidelines discouraged banks from

borrowing a t the discount window.

Therefore, i t took a greater spread between

the federal funds r a t e and the discount rate t o induce more banks t o borrow a t
the window.

An unexpectedly 1arge increase i n the money stock induced a

corresponding s h i f t in the expected reserve demand curve.

Expectations about

the c o s t of federal funds adjusted t o r e f l e c t new information about the
aggregate demand f o r reserves.

In panel b of figure 1 , i t i s c l e a r t h a t a

d
surprise increase i n the demand f o r reserves, from RBd t o RA,
caused

the federal funds rate t o r i s e from FFB t o FFA.
An important aspect of the nonborrowed reserve operating target i s the

automaticity i n the response of i n t e r e s t rates t o a deviation of MI from the
short-run path.

Under this procedure, deviations of the other aggregates are

automati cal ly accommodated by the weekly mu1 ti pl i e r adjustments t o the
nonborrowed reserve path.

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In the second half of 1982, the FOMC decided t h a t i t d i d not wish t o react
automatically t o deviations of Ill from path.

This decision was based on the

uncertainty surrounding financial innovations, changing regulations, and the
unusual behavior of MI velocity.

In October 1982, the FOMC adopted a

procedure based on a target f o r borrowed reserves and an assumption
(prediction) about excess reserves.

Under L R R , the Federal Reserve had

relatively accurate information about reserve demand.

The desk s e t

nonborrowed reserve targets each week based on a forecast of reserve demand
and the borrowing target chosen by the FOMC.

Each week, the desk adjusted the

nonborrowed reserve path ( N B R ) to accommodate the s h i f t in reserve demand.
The procedure i s portrayed i n panel c of figure 1.

The announcement of an

unexpectedly large increase i n M1 was accompanied by a compensating s h i f t i n
NBR so t h a t the borrowing target was maintained.

On a weekly average basis

t h i s procedure 1ooked much 1i ke the i nterest- rate operating procedure t h a t was
i n e f f e c t before October 1979.

One difference was t h a t any rotation of the

borrowing demand curve led t o a different federal funds rate.
During the nonborrowed reserve procedure, the Federal Reserve entered the
market once a day, usually between 11:30 am and noon.

The operation was

primarily defensive; i . e . , i t was a response t o movements i n the
uncontroll able sources of reserve supply.

To a 1arge extent, that intra-week

procedure was continued w i t h the borrowing target.

The market participants

did not know the exact amount of the borrowing t a r g e t , nor d i d they know the
exact 1ocation of the borrowing function.

Consequently, they could not narrow

down a small range f o r the funds rate as they had done prior to October 1979.
The weekly averages were very stable, b u t daily v o l a t i l i t y made i t more
d i f f i c u l t f o r the market t o perceive changes i n the stance of policy than had
been the case when the federal funds r a t e was the operating target.

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Nevertheless, on a weekly basis, t h e borrowing t a r g e t c o u l d be described as a
federal funds r a t e smoothing procedure.

Because o f lagged reserve

requirements, the money stock announcement s t i l l contained i n f o r m a t i o n about
t h e aggregate demand f o r reserves.

However, because o f borrowed reserve

t a r g e t i n g , market p a r t i c i p a n t s expected the Federal Reserve t o accommodate an
u n a n t i c i p a t e d s h i f t i n t h e demand f o r reserves by a d j u s t i n g nonborrowed
reserves.

Therefore, one would expect no s i g n i f i c a n t r e a c t i o n o f t h e f e d e r a l

funds r a t e t o money stock announcements.
F i n a l l y , the r e c e n t change i n t h e reserve s e t t l e m e n t r u l e s has i m p o r t a n t
i m p l i c a t i o n s f o r t h e e f f e c t o f money stock announcements on t h e f e d e r a l funds
rate.

Before February 2, 1984, t h e d e v i a t i o n of t h e money stock announcement

from t h e expected l e v e l gave t h e market two types o f i n f o r m a t i o n : t h e f i r s t
was information about t h e aggregate q u a n t i t y o f reserves t h a t would be
demanded over the n e x t few t r a d i n g days; t h e second was i n f o r m a t i o n about t h e
p o s i t i o n o f t h e money stock r e l a t i v e t o the perceived p o l i c y t a r g e t .

Under

t h e hypothesis t h a t p r i c e s i n e f f i c i e n t markets aggregate i n f o r m a t i o n , the
money stock announcements no l o n g e r i n c l u d e new i n f o r m a t i o n about aggregate
r e s e r v e demand.

That i n f o r m a t i o n w i l l already be apparent from t h e i n t e r e s t

r a t e s t h a t p r e v a i l e d d u r i n g the reserve settlement p e r i o d t h a t w i l l have ended
before t h e money stock d a t s are released.

The market w i l l a l s o have b e t t e r

i n f o r m a t i o n about t h e money stock r e l a t i v e t o t h e perceived pol i c y t a r g e t .

To

some e x t e n t i t w i l l be i n f e r r e d from t h e i n f o r m a t i o n i n aggregate reserves.
Furthermore, banks i n s t a l l e d new i n f o m a t i o n - g a t h e r i n g systems t o meet reserve
requirements on a contemporaneous basis.

Many arrangements have been made by

banks and p r i v a t e f i r m s t o pool d e p o s i t i n f o r m a t i o n i n a way t h a t mimics t h e
process o f deposit data c o l l e c t i o n used by t h e Federal Reserve.

These f a c t o r s

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suggest t h a t t h e r e w i l l n o t be a s i g n i f i c a n t c o r r e l a t i o n between s u r p r i s e s i n
t h e money stock announcements and subsequent changes i n asset p r i c e s .

IV.

Empirical Resul t s

The e m p i r i c a l r e s u l t s presented i n t h i s s e c t i o n a r e based on estimates o f
t h e parameters o f equation 1, shown i n t h e i n t r o d u c t i o n .

The assets i n c l u d e d

i n t h i s study a r e t h e f e d e r a l funds r a t e , a trade- weighted d a i l y average; t h e
coupon- equivalent y i e l d on three- and twelve-month Treasury b i l l s ; and t h e
constant m a t u r i t y y i e l d on three- year, seven-year, and t h i r t y - y e a r Treasury
bonds.''

(See appendix A f o r a d e t a i l e d d e s c r i p t i o n o f t h e data. )

money stock announcement was made a t 4:15 o r 4:30 pm EST.

The

Estimates o f al

and a* f o r domestic i n t e r e s t r a t e s a r e r e p o r t e d i n t h e t o p o f t a b l e s 2 and 3.
We have f o l l o w e d t h e suggestion o f S h i l l e r , Campbell, and Schoenholtz by
i n c l u d i n g t h e forward i n t e r e s t r a t e s i m p l i e d by t h e expectations t h e o r y o f t h e
term s t r u c t u r e .

We use S h i l l e r ' s (1979) duration- adjusted 1 i n e a r

approximation t o c o n s t r u c t t h e i m p l i e d forward r a t e s .

Estimates o f al and

a* f o r t h e i m p l i e d forward r a t e s a r e shown i n t h e middle o f t a b l e s 2 and 3.
I n a d d i t i o n , we examine the r e a c t i o n s o f t h e dollar/mark spot r a t e , t h e
three-month dollar/mark forward r a t e , and t h e twelve-month dollar/mark forward
r a t e t o money stock announcements.

These r e s u l t s a r e shown i n t h e bottom o f

t a b l e s 2 and 3.
The f u l l sample p e r i o d s t a r t s on September 28, 1977, and ends on September
21, 1984.

We assume t h a t t h e r e was a s w i t c h from a p o l i c y t h a t l e d t o

a c c e l e r a t i n g i n f l a t i o n b e f o r e October 1979 t o a pol i c y t h a t emphasized
d i s i n f l a t i o n a f t e r October 1979.
d i f f e r e n t o p e r a t i n g procedures:

The e s t i m a t i o n p e r i o d i n c l udes t h r e e
a f e d e r a l funds r a t e o p e r a t i n g procedure from

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-

Table 2

30 Impact of Money Stock Surprises on Asset Prices ( a l )
Operating t a r g e t

Federal
funds

LRR
Nonborrowed
reserves

Borrowed
reserves

Federal funds r a t e

0.01 8
(0.87)

0. 378a
(4.04)

0.098
(1.50)

0.043~
(0.34)

3-month Treasury

0.072
(3.11

0.364
(6.58)

0.1 90
(5.77)

0.01 9
(0.45)

1 2-month Treasury

0.072
(4.73)

0.338
(7.59)

0.21 6
(5.62)

0.020
(0.32)

3-year govt. bond

0.041
(4.63)

0.263
(7.43)

0.185
(5.11)

-0.001
(-0.02)

7-year govt. bond

0.027
(3.42)

0.1 88
(6.60)

0.1 85
(5.94)

-0.002
(-0.03)

30-year govt. bond

0.01 6
(2.95)

0.115
(4.48)

0.1 50
(4.86)

( -0.27)

9-month forward r a t e
3-mon t h a head

0.072
(4.80)

0.329
(7.35)

0.225
(5.43)

0.020
(0.27)

2-year forward r a t e
1-year ahead

0.01 8
(1.69)

0.21 9
(6.48)

0.1 67
(4.41 )

-0.01 4
(-0.19)

4-year forward r a t e
3-years ahead

0.01 6
(1.49)

0.101
(3.90)

0.185
(5.86)

( -0.04)

23-year forward r a t e
7-year ahead

0.007
(0.97)

0.01 3
(0.65)

0.1 08
(3.01 )

-0.036
(-0.59)

Do1 1ar/mark spot
exchange r a t e

0.1 05
(1.08)

-0.438
(-3.82)

-0.607
(-3.19)

0.117
(0.30)

Do1 1ar/mark 3-month
forward exchange r a t e

0.134
(1.35)

-0.343
(-3.12)

-0.556
(-2.95)

0.131
(0.33)

Do1 1ar/mark 1 2-month
forward exchange r a t e

0.369
(2.44)

-0.221
(- 2.08)

-0.476
(-2.61 )

0.1 82
(0.45)

Dependent v a r i a b l e

a

CRR
Borrowed
reserves

-0.01 6

-0.003

a Indicates s i g n i f i c a n t f i rst- order autocorrel ation. These parameters were
estimated using a Cochrane-Orcutt procedure. The t - s t a t i s t i c s a r e shown i n
parentheses.

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Table 3

-

31 Impact of Expected Money Stock Changes on Asset Prices ( a 2 )
Operating t a r g e t

Dependent vari abl e

LRR
Nonborrowed
reserves

Federal
funds

CRR

a

Borrowed
reserves

Borrowed
reserves

-0.033
(-0.47)

-0.324
(-2.36)

Federal funds r a t e

-0.021
(-0.81 )

-0.167
(-1.03)

3-month Treasury

-0.045
(-1.61 )

-0.31 0
(-3.28)

-0.050
(-1 -41 )

-0.085
(-1.85)

1 ?-month Treasury

-0.037
(2.03)

-0.231
(-3.03)

-0.079
(-1.90)

-0.094
(- 1.34)

3-year govt. bond

-0.030
(2.95)

-0.140
(-2.30)

-0.083
(-2.12)

-0.069
(-0.94)

7-year govt. bond

-0.015
(- 1.58)

-0.136
(-2.81)

-0.093
(-2.76)

-0.068
(-.92)

30-year govt. bond

-0.01 3
(-1.90)

-0.167
(-3.79)

-0.067
(-2.00)

-0.100
(-1.49)

9-month forward r a t e
3-month ahead

-0.035
- 1.91

-0.204
(-2.66)

-0.089
(-1.98)

-0.097
(-1 .I61

2-year forward r a t e
1- year ahead

-0.01 9
(-1.47)

-0.085
(-1.47)

-0.085
(-2.08)

-0.084
(-0.66)

4-year forward r a t e
3-years ahead

-0.009
(-0.66)

-0.133
(-2.98)

-0.105
(-3.06)

-0.066
(-0.80)

23-year forward r a t e
7-years ahead

-0.01 1
(-1.29)

-0.207
(-4.19)

-0.035
(-0.90)

-0.146
(-2.12)

Do1 1ar/mark s p o t
exchange r a t e

-0.068
(-0.58)

0.522
(2.66)

-0.606
(-3.19)

0.01 0
(0.02)

Do1 1ar/mark 3-month
forward exchange r a t e

-0.05
(-0.42)

0.462
(2.45)

-0.102
(0.79)

0.01 1
(0.03)

Do1 1ar/mark 12-month
forward exchange r a t e

-0.075
(-0.41 )

0.429
(2.36)

0.1 53
(0.77)

0.047
(0.11

a

- - -

a.

See fn a , t a b l e 2.

a

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the beginning of the sample period until October 6, 1979; the nonborrowed
reserve operating procedure from October 6, 1979, until October 5, 1982; and
the current borrowed reserve operating procedure t h a t was adopted i n October
1982.

There are two reserve accounting regimes: lagged reserve requirements

before February 2, 1984, and contemporaneous reserve requirements afterward.

September 1977 t o October 1979
The r e s u l t s from the pre-October 1979 period provide support f o r the
hypothesis that the money stock announcement during t h i s period contained
information about future inflation.

The estimate of al was positive and

significant a t a 5 percent c r i t i c a l level for a l l of the domestic i n t e r e s t
rates except the federal funds rate.
funds rate was expected.

The lack of response of the federal

The market anticipated t h a t the Federal Reserve

would accommodate the unexpected s h i f t s in the demand f o r reserves;
consequently, the cost of obtaining reserves the remaining days of the
settlement week was expected t o remain relatively unchanged.

All of the

imp1 ied forward rates responded positively to the money stock surprises, b u t
only in the case of the three-month ahead, nine-month r a t e was the response
significantly different from zero a t the 5 percent level.
By themselves the interest- rate results are consistent with almost any of
the alternative hypotheses.

Following the suggestion of Engel and Frankel, we

look a t the reaction i n the spot dollar/mark exchange market.

A1 though the

do1 1a r depreciated f o l l owing a positive money stock surprise, the response in
the spot market was not s t a t i s t i c a l l y significant.

The dollar also

depreciated in the three- and twelve-month forward exchange markets following
a positive surprise i n the money stocl: announcement.

The response of the

twelve-month forward exchange r a t e i s s t a t i s t i c a l l y significant a t the 5

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percent level.

These findings provide support f o r the inflation premium

hypothesis over the policy anticipation hypothesis and f o r our assumption t h a t
the pre-October 1979 period can be characterized as an inflationary monetary
pol icy regime.

October 1979 t o October 1982
During the period of the nonborrowed reserve operating procedure, the
reactions of a l l domestic i n t e r e s t rates were much greater than before.

In

the e a r l i e r period, a 1 percent positive surprise i n the money stock led t o a
7-basis-point increase i n the three-month Treasury b i l l r a t e and a 1.5basis-point increase i n the thirty- year Treasury bond rate.

In the period of

nonborrowed reserve targeting, the reactions of these rates were considerably
stronger, 36 and 11.5 basis points, respectively.

Furthermore, the response

of the federal funds rate to money stock surprises was stronger and
s t a t i s t i c a l l y significant a t the 5 percent level.

Participants i n the reserve

market understood that a positive surprise i n the aggregate demand f o r
reserves w i t h i n the settlement week would lead to a higher cost of borrowing
reserves for the remainder of the settlement week.
There was also a dramatic change in the response i n exchange markets.

The

spot and forward dollar exchange rates appreciated sharply against the mark
following a positive money stock announcement.
the e a r l i e r period.

This was a sharp reversal from

Engel and Frankel attributed t h i s reversal in the spot

market t o a change in the real i n t e r e s t r a t e caused by expected liquidity
effects.

This explanation i s inconsistent with the significant reaction of

the forward i n t e r e s t rates several years out and the twelve-month ahead
forward exchange rates.

Furthermore, i t does not explain the significant

depreciation of the forward exchange rate i n the e a r l i e r period.

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Me a t t r i b u t e the appreciation of the d o l l a r and the strong upward reaction
of i n t e r e s t rates subsequent to a positive money stock surprise during t h i s
period t o the policy regime change.

Money stock announcements provided the

market with information about persistent money demand shocks t h a t the Federal
Reserve was not expected to acco~mnodatefully.

Following a positive money

stock surprise, the market revised upward i t s assessment of current and future
real i n t e r e s t rates, leading t o an appreciation of the spot and forward values
of the do1 l a r .

October 1982 t o February 1984
The next period i s interesting, because i t allows us to t e s t whether the
change in the operating procedure can be viewed as a change i n the policy
regime.

After October 1982, the Federal Reserve began t o target borrowed

reserves.

Since this i s an interest- rate smoothing procedure, the federal

funds r a t e was not expected to respond t o the announcements.

The response of

the federal funds r a t e during t h i s period was s t a t i s t i c a l l y insignificant.
The pattern of responses of i n t e r e s t r a t e s and exchange rates i s similar
t o the one ohserved in the period of nonborrowed reserve targeting.

The

longest-term i n t e r e s t rates and the forward exchange rates react more strongly
in this period than they d i d during the nonborrowed reserve operating
procedure.

This suggests to us that the strong response of asset prices,

other than the federal funds rate, resulted from disinflation policy and not
from the change in operating procedures.

The dramatic difference between the

pattern of responses under borrowed reserve targeting procedures and under the
interest- rate targeting procedures suggests t h a t the operating procedure d i d
not determine the policy regime for t h i s sample period.

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February 1984 t o September 1984
As predicted, t h e money supply announcements appear t o be i r r e l e v a n t .
Estimates o f al a r e n o t s t a t i s t i c a l l y s i g n i f i c a n t f o r any o f t h e assets we
examined.

T h i s " surprise 1 ' we measure i n c l u d e s i n f o r m a t i o n t h a t has been

revealed i n the c l e a r i n g o f t h e reserve market b e f o r e t i l e rrioney stock i s
announced.

Furthermore, each i n d i v i d u a l p a r t i c i pant now h r i ngs b e t t e r ( 1ocal )

i n f o r m a t i o n t o t h e reserve market c l e a r i n g .
upgrade t h e i r own deposi t-moni t o r i ng systems.

Under CRR, banks have had t o
Banks and information- service

companies such as Money Market Services have developed more s c i e n t i f i c
i n f o r m a t i o n - p o o l i n g systems t o r e p l i c a t e t h e Federal Reserve's procedure f o r
c o n s t r u c t i n g t h e f i rst-pub1 ished M I data.

The R a t i o n a l i t y o f t h e Survey Forecasts
The estimates o f ap are shown i n t a b l e 3.

According t o t h e e f f i c i e n t

market hypothesis, t h i s c o e f f i c i e n t should be zero.

However, we f i n d t h a t t h e

c o e f f i c i e n t i s s i g n i f i c a n t l y l e s s than zero i n many cases across a l l regimes.
We suggest t h a t the negative s i g n r e s u l t s because t h e survey i s an i n e f f i c i e n t
f o r e c a s t o f t h e expected change i n F11.

The agents p a r t i c i p a t i ' n g i n t h e survey

a r e o n l y a subset o f those p a r t i c i p a t i n g i n t h e market.

The median survey o f

t h e i r opinions i s l e s s e f f i c i e n t than t h e market o p i n i o n embedded i n t h e
i n t e r e s t r a t e j u s t p r i o r t o t h e announcement.

This market

o p i n i o n i s a trade- weighted o p i n i o n o f a l l t h e p a r t i c i p a n t s i n t h e market.
Since t h i s i n t e r e s t r a t e e n t e r s t h e dependent v a r i a b l e w i t h a n e g a t i v e sign,
we g e t a negative s i g n f o r a*.

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Concl usion

Our main objective i n t h i s paper i s t o explain the changing patterns of
response by asset prices t o money stock announcements during several
subperiods between 1977 and the present.

Previous work i n t h i s area has not

distinguished between policy regimes and operating procedures.

Furthermore,

we can now include evidence from a new operating procedure and new reserve
accounting rules.
market.

We also include information from the forward exchange

By taking account of forward exchange rates and the i n s t i t u t i o n a l ,

procedural, and policy changes, we are able t o resolve ambiguities t h a t remain
i n published work.

F i r s t , we show that the pattern of response of the federal funds r a t e to
money stock surprises during d i f f e r e n t subperiods over the l a s t seven years
depends on the Federal Reserve's operating procedure and the reserve
accounting rules.

Second, we show t h a t a change i n the operating procedure

does not necessarily imply a change i n the monetary policy regime.

In t h i s

context, we show t h a t the positive response of asset prices t o money stock
surprises i n the pre-October 1979 period resulted from an inflation premium.
In contrast, the response of a s s e t prices to money stock surprises i n the
post-October 1979 period resulted from a change i n the expected real i n t e r e s t
rate.

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Appendix A

Data Sources

MI
-

M1 i s t h e f i g u r e f i r s t published by t h e Federal Reserve i n t h e H.6 press
release.

The expected change i n M I i s c a l c u l a t e d u s i n g t h e median o f a survey

taken by Money Market Services.
of d o l l a r s .

The expected changes (MMSP) a r e i n b i l l i o n s

The expected change i n M I (EM i n t h e t e x t ) i s c a l c u l a t e d as:

+ MMSPt)

EMt = l o g (M1t-l

-

l o g (Mlt-l),

where t r e f e r s t o t h e week o f t h e announcement r a t h e r t h a n t h e statement week
f o r which M I was c a l c u l a t e d .

The s u r p r i s e i n M I (UM i n t h e t e x t ) i s

c a l c u l a t e d as:
UMt = 1og (MI t )

-

109 (MI t-l + I*IMSPt).

We have used f i r s t - p u b l i s h e d numbers r a t h e r than r e v i s e d numbers i n making
these c a l c u l a t i o n s .
change.

This amounts t o t r e a t i n g t h e r e v i s i o n as an unexpected

Roley ( 1 982) shows r e s u l t s t h a t are i n v a r i a n t t o t h e use o f

f i r s t - p u b 1 i shed o r r e v i s e d data.

He concludes t h a t t h e r e v i s i o n s should n o t

be t r e a t e d as unexpected changes i n M I .
December 1979 period.

However, he excluded t h e October t o

Mhen t h i s p e r i o d i s included, we f i n d t h a t t h e

r e v i s i o n s have the same e f f e c t on asset p r i c e s as t h e unexpected changes i n M I .
We used t h e M I s e r i e s t h a t was published i n t h e H.6 release.
d e f i n i t i o n o f M I changed, our measure changed.

When t h e

Overlapping data were used t o

s p l i c e t h e s e r i e s i n e a r l y 1980 when t h e Federal Reserve changed t h e
d e f i n i t i o n o f M1 t o i n c l u d e o t h e r checkable deposits.

I n t e r e s t Rates and Exchange Rates
The i n t e r e s t r a t e s and exchange r a t e s come from t h e data banks o f Data
Resources Inc.

The o r i g i n a l source f o r the i n t e r e s t r a t e s i s t h e H.15

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release.

The original source f o r the exchange rates is the Bank of America.

Since the H.6 release (Money Announcement) was made on various days throughout
the sample period, we collected daily data.

A "before-announcementn r a t e was

taken as the l a s t available value before the announcement.

The

1

''after-announcement ' r a t e was taken as the f i r s t available value a f t e r the
announcement.

There i s always a t l e a s t a 24-hour span between the "before"

and "after" quote.

The major e f f e c t of t h i s procedure i s to reduce the R 2

i n the estimate of equation 1 i n the text.

There i s no reason why the

parameters of equation 1 should be biased unless there are other factors t h a t
are correlated w i t h the surprise i n the money stock announcement.

Details f o r

each of the a s s e t prices are l i s t e d below:
Federal funds rate.

The effective federal funds r a t e i s a trade-weighted

average f o r the day.
The three- and twelve-month Treasury b i l l yields are

Treasury b i l l s .

based on the bid quotes a t the close of the New York market (4:00 pm EST).
Treasury coupons.

The three-, seven-, and thirty- year yields are based on

the b i d quotes a t the close of the New York market.

We have used yields

calculated a t "constant maturity" from the Treasury's daily yield curve.
Implied forward rates.

These rates are calculated using the following

formula from Shil l e r , Campbell, and Schoenhol t z (1983):

where
f k n y m )= 1inearized approximation to the n period ahead m period
forward rate,

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R t i ) = y i e l d on an i-period bond a t time t, and
= duration of bonds maturing in

m+n periods.

Di i s calculated from the following formula:
i
Di = (1-g ) / ( I - g ) ; o < i ,

where
g = 1 / ( l + E ) , and

-R = mean R

f o r each sub-sample period between September 1977 and

September 1384.

3/4) forward r a t e i s calculated d i r e c t l y from the

Of course, the f

formula f o r the implied forward r a t e as there are no coupons on Treasury
b i l l s.

The values f o r

and Di a r e given in Table Al.

Table A1

Assumed values f o r
Maturity

-

Sept 1977

-

Oct 1979

3 year
7 year
30 year

Oct1982-Feb1984

3year
7 year
30 year

-

3 year
7 year
30 year

Feb 1984

Sept 1984

Do1 1ar/mark exchange r a t e s .

-R

Di

3 year
7 year
30 year

Oct 1982

Oct 1979

and Di

The foreign currency exchange r a t e s a r e

expressed as bids reflecting opening prices in the New York markets.
Rates are quotes in U.S. terms (do1l a r s per deutschemark).

The dependent

variable in the t e x t i s the f i r s t difference of the logarithm.

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Footnotes
1

.

See, f o r example, Cornel 1 (1 983b), Engel and Frankel ( 1 984), Hardouvel i s
(1 984), Loeys (1 984), Rol ey (1 983), Shi 11er, Campbell , and Schoenhol t z
(1983), U r i c h and Wachtel (1981 1, and U r i c h (1982).

2. Hoehn ( 1984) presents a t r a d i t i o n a l macroeconomic model w i tli I r a t i o n a l
e x p e c t a t i o n s and a h i g h l y d e t a i l e d lnonetary sector. He shows t h a t t h e
reduced- form equations f o r t h e p r i c e l e v e l , output, and t h e i n t e r e s t r a t e
change when t h e o p e r a t i n g procedures change.
3. See Engel and Frankel (1 984).

4. Cornel 1 ( 1 983b) suggests a r i sk-premi um hypothesis. We have n o t in c l uded
i t because he d i d n o t f i n d evidence t o support it. Furthermore, Makin
(1983) shows t h a t t h e t h e o r e t i c a l e f f e c t o f p o l i c y u n c e r t a i n t y on asset
p r i c e s i s ambiguous. I n h i s e m p i r i c a l work he f i n d s a s i g n opposite t o
t h a t p r e d i c t e d by C o r n e l l .
5. See Brayton, F a r r , and P o r t e r (1983) f o r an econometric study o f t h i s
issue.
6. An e x p l i c i t d e r i v a t i o n o f the r e l a t i o n s h i p between the r e a l i n t e r e s t r a t e
and t h e Mundell-Tobin wealth e f f e c t i s provided i n Makin (1983).
7. See f n 5.
8. See Stevens (1 981 ) f o r a d e t a i l e d d e s c r i p t i o n o f p o l i c y d u r i n g t h e f i r s t
two y e a r s o f the nonborrowed r e s e r v e t a r g e t i n g procedure.
9. Goodfriend (1983) uses a micro- based model t o show t h a t the borrowing
r e l a t i o n i s non- linear. He shows t h a t i t i s a f u n c t i o n o f p a s t and
expected f u t u r e borrowing, which depends on t h e expected f u t u r e f e d e r a l
funds r a t e .
10. See appendix A f o r a d e t a i l e d d e s c r i p t i o n o f data. The m a t u r i t i e s used i n
t h i s study were chosen because S h i l l e r , Campbell, and Shoenhol t z (1 983)
and Loeys (1984) have found t h a t t h e r e tends t o be a s i m i l a r response
among s e c u r i t i e s w i t h m a t u r i t i e s between one and t h r e e years, between
t h r e e and seven years, and again w i t h m a t u r i t i e s over seven years.
11. While t h e e m p i r i c a l evidence presented be1ow lends credence t o t h i s
assumpti on, there i s supporting evidence. Bagshaw and Gavin ( 1984) show
t h a t a f t e r 1979 t h e Federal Reserve d e v i a t e d from i t s M1 t a r g e t o n l y
d u r i n g periods when t h e r e was an o f f s e t t i n g s h i f t i n v e l o c i t y . T h i s was a
marked change from t h e 1976 t o 1979 p e r i o d d u r i n g which M I grew above
t a r g e t , r e i n f o r c i n g t h e i n f l a t i o n a r y e f f e c t s o f unexpected increases i n
v e l o c i t y growth.
12. See Roley (1983) f o r e m p i r i c a l support o f t h i s hypothesis.

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