News and the Exchange Rate Revisited IGNACIO MAULEON* ABSTRACT This paper provides a theoretical framework to explain the increasing impact on the exchange rate of unanticipated money growth, with a stable short-term interest rate, and rising long-term rates. The assumptions of Purchasing Power Parity and Uncovered Interest Rate parity are relaxed. The appreciation of the currency is shown to be a direct result of the expected increase of future interest rates. A discussion is offered on the precise definition of the "surprise," under alternative assumptions. Heterogeneity of agents as regards exchange rate expectations, and the effect of long-term capital investments are also taken into account. It is shown that the surprise may have lagged effects on the exchange rate, and that its sign depends on the horizon of the portfolio investments (short or long). (JEL E50, F30) INTRODUCTION The subject of unanticipated money growth impacts on the interest rate has received attention in the literature in the past, although more from an empirical than a theoretical point of view (see, for example, Huizinga and Leiderman [1987]; Mankiw et al. [1984]; Urich [1982]; Nichols et al. [1984]; Hardouvelis [1984]; Cornell [1983]; and Green and Lewellyn [1991] for a survey). A related topic, not so extensively discussed in the literature, however, is the impact of unanticipated money growth on the exchange rate (see, for instance, Engel and Frankel [1984] and Smith and Goodhart [1985]). The topics are of interest, since what could be expected under almost any traditional macroeconomic model is that money growth would lead to interest rate declines and depreciation (which is not always the case in practice). Besides, and according to Frankel and Rose [1994], the theoretical models on exchange rates only have proved to have some explanatory power in the very long run and in the form of reaction to news, or unanticipated economic (or political) shocks. The analysis of money growth impacts on the exchange rate has again become the focus of practical (if not theoretical) attention in some financial markets. For example, member countries of the European Monetary System (EMS) try to stabilize the exchange rate, and yet, they try to follow simultaneously a monetary policy based on money growth targets. This has recently made the mechanism to become empirically relevant again. More than expected or excessive money growth in one country causes its domestic currency to "Universidad de Salamanca--Spain.This paper has benefited fromthe comments of the participantsat the 1996 International AtlanticEconomic Conference in Paris. Financialsupport fromthe InstitutoValenciano de InvestigacionesEcon6micas and the DGCYTunderprojectPB94-1502 is acknowledged. 300