Problem
The Federal Reserve announces how quickly the money supply grew in the week ending ten days previously. (There is a ten-day delay because it takes that long to assemble data on bank deposits.) Economists have noticed that when the announced increase in the money supply is greater than expected, nominal interest rates rise just after the announcement; they fall when the market learns the money supply grew more slowly than expected. Two competing explanations of this phenomenon are (1) unexpectedly high money growth raises expected inflation and thus raises nominal interest rates through the Fisher effect; and (2) unexpectedly high money growth leads the market to expect future Fed action to reduce the money supply, causing a decrease in the amount of deposits supplied to the public by banks but no increase in expected inflation. How would you use data from the foreign exchange market to decide between these two hypotheses? (For an answer, see the paper by Engel and Frankel in Further Reading.)
The response should include a reference list. Double-space, using Times New Roman 12 pnt font, one-inch margins, and APA style of writing and citations.