Monetary Innovations and Interest Rates

Abstract

THIS PAPER EXAMINES THE EFFECT OF unexpected weekly changes in the money supply on financial markets. l Examination of financial market reaction to weekly monetary surprises provides information on how the economy reacts to monetary changes. Also, the reaction to weekly monetary surprises may put real or imagined constraints on Federal Reserve behavior. As noted by Tobin a decade ago, Certainly the rate of growth of the money stock has become the customary capsule form for describing monetary and gauging how easy or tight it is. For a time it seemed that public preoccupation with this number might itself be a market constraint on the Federal Reserve. Believers in monetarism would regard accelerated growth of M1 as the harbinger of more inflation and higher interest rates. If such people were to dominate financial markets, they would make it difficult for the Fed to carry out a rate-reducing expansionary policy (Tobin 1974, p. 70). Throughout the paper, unexpected weekly changes in the money supply (monetary innovations) are measured by reported changes in the supply of money minus expected changes, where expected changes in money are obtained from market survey data. Changes in current interest rates of various terms to maturity are used to measure the effects of innovations on financial markets.

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