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Monetary Targets, Interest Rates and Exchange Rates

Two distinct models of rational economic behaviour may be useful in explaining an apparent change in the relationship between short-term US interest rates and the US money supply. These models are implicit in the recent rational expectations literature which includes Lucas (1972), Fischer (1977), Phelps and Taylor (1977), Poole (1976) and Sargent and Wallace (1975). Yet, the two models give flatly contradictory results.In the first model, the market is rational because it understands how policy makers, particularly the monetary authorities, behave and forecasts future monetary policy with some degree of accuracy. When the money growth rate rises above target in the United States, for example, market participants forecast a future increase in the Federal Funds rate aimed at slowing growth of the money stock in some future period. In this case the monetary authority is monetarist but the market need not be. The authorities believe that inflation is a monetary phenomenon and the money stock is controlled to achieve a desired inflation rate. The market need only understand how the monetary authority behaves.