The Impact of Changes in the Federal Reserve's Discount Rate on the Dollar's Foreign Exchange Value

Abstract

This paper attempts to analyze the effects of changes in the Federal Reserve's discount rate on the dollar's foreign exchange value. It a discount rate increase were to signal a subsequent general increase in market interest rates, one would expect U.S. dollar-donominated assets to become relatively more attractive, and the ensuing increase demand for dollar assets to tend to raise the dollar's exchange value. The reverse would be true for discount rate decreases. However, 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 a case, announcement effects -- immediate and dinsernable market responses to discount rate changes -- do not occur. Under special circumstatnes in 1978, however, announcement effects could and did occur. By increasing the discount rate when the Federal funds-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 teh monetary base.