Abstract
This paper attempts to analyze the effects of changes in the Federal Reserve's discount rate on the dollar's foreign exchange value. If a discount rate increase were to signal a subsequent general increase in market interest rates, one would expect U. S. dollar-denominated assets to become relatively more attractive, and the ensuing increased demand for dollar assets to tend to raise the dollar's exchange value. The reverse would be true for discount rate decreases. However, in recent years the Federal Reserve's policy of moving the discount rate with a lag behind the Federal funds rate means that market participants generally have sufficient information to anticipate changes in the discount rate. When this is the case, announcement effectsimmediate and discernible market responses to discount rate changes-do not occur. Under special circumstances in 1978, however, announcement effects could and did occur. By increasing the discount rate when the Federal funds-discount rate differential was around normal levels and by increasing the discount rate by a larger amount than the market anticipated, the Federal Reserve used the discount rate as a signal to market participants that it would use other operating instruments to bring about changes in market interest rates and the monetary base. In their 1977 article, Raymond E. Lombra and Raymond G. Torto ran a number of econometric tests for discount rate exogeneity on monthly data from January 1968 to May 1974. They concluded that discount rate movements were not independent of the spread between the discount rate and the Federal funds rate. Given rational expectations, therefore, changes in the discount rate could not generate announcement effects [Lombra and Torto, 1977]. This paper updates the work of Lombra and Torto and then attempts to test directly
Published Version
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