Tools of Monetary Policy Chapter 17 Tools of Monetary Policy Copyright  2011 Pearson Canada Inc.

The Large Value Transfer System (LVTS) I The LVTS (introduced in 1999) electronic, real-time net settlement network designed to provide immediate finality and settlement to time-critical transactions LVTS participants know in real time their large-value, wholesale transactions (over $50,000). Transactions account for < 1% of the total number of transactions They make up 94% of the value of transactions in Canada Copyright  2011 Pearson Canada Inc.

The Large Value Transfer System (LVTS) II The LVTS uses multilateral netting — only the net credit or debit position of each participant vis-à-vis all other participants is calculated for settlement Copyright  2011 Pearson Canada Inc.

Systemic Risk The LVTS has been put in place to eliminate systemic risk. In fact, participants can make a payment only if: they have positive settlement balances in their accounts with the Bank of Canada, posted collateral (such as T-bills and bonds), or explicit lines of credit with other LVTS participants Copyright  2011 Pearson Canada Inc.

Non-LVTS Transactions These are non-LVTS (paper-based) payment items, such as cheques These items are cleared through the Automated Clearing Settlement System (ACSS), an electronic payments system also operated by the CPA The ACSS aggregates interbank payments and calculates the net amounts to be transferred from and to each participant's settlement account with the Bank of Canada Direct Clearers are subset of LVTS participants who participate directly in the ACSS Copyright  2011 Pearson Canada Inc.

The Operating Band for the Overnight Interest Rate I The interest rate at which participants borrow and lend overnight funds to each other is known as the overnight interest rate The Bank of Canada implements monetary policy by changing the overnight interest rate. Such changes influence other short-term interest rates and the exchange rate Copyright  2011 Pearson Canada Inc.

The Operating Band for the Overnight Interest Rate II The Bank’s objective is to keep the overnight rate within a band of 50 basis points Since December 2000, the Bank operates under a system of eight “fixed” dates throughout the year for announcing changes to the operating band Copyright  2011 Pearson Canada Inc.

The Operating Band for the Overnight Interest Rate III Copyright  2011 Pearson Canada Inc.

The Bank’s Standing Liquidity Facilities I At the end of each day, each LVTS participant must bring its settlement balance with the Bank close to zero. The Bank therefore stands ready (standing facilities) to provide or absorb liquidity with an overnight duration to participants facing unforeseen liquidity shocks. Copyright  2011 Pearson Canada Inc.

The Bank’s Standing Liquidity Facilities II The initiative is on the side of the LVTS participant. A participant may use the Bank’s lending facility to obtain (against eligible collateral) overnight liquidity in case of a shortage, or it may use the deposit facility to make deposits in case of excess liquidity. Copyright  2011 Pearson Canada Inc.

The Bank of Canada and the Operating band If the overnight rate increases toward the upper limit of the operating band, then the Bank will lend at the bank rate to put a ceiling on the overnight rate If the overnight rate falls toward the lower limit of the operating band, then the Bank will accept deposits from LVTS participants at the bank rate less 50 basis points – putting a floor on the overnight rate Copyright  2011 Pearson Canada Inc.

The Bank of Canada and the Operating band If the overnight rate increases toward the upper limit of the operating band, then the Bank will lend at the bank rate to put a ceiling on the overnight rate If the overnight rate falls toward the lower limit of the operating band, then the Bank will accept deposits from LVTS participants at the bank rate less 50 basis points – putting a floor on the overnight rate Copyright  2011 Pearson Canada Inc.

The Channel/Corridor System for the Overnight Rate Copyright  2011 Pearson Canada Inc.

Demand for Reserves Demand Curve As the overnight interest rate decreases the opportunity cost of holding desired reserves falls and ceteris paribus, the quantity of reserves demanded rises. Rd slopes downward Copyright  2011 Pearson Canada Inc.

Supply Curve for Reserves quantity of reserves supplied is infinitely elastic at ib Also flat at ib -0.50 because banks would not ledn in the overnight market Between ib -0.50 and ib, banks will not borrow from the Bank and borrowed reserves (BR) equal zero (cheaper to borrow in overnight market) Copyright  2011 Pearson Canada Inc.

The Channel/Corridor System for the Overnight Rate In terms of Figure 17-2, the equilibrium interest rate will always be within the operating band The system enables the Bank to keep the overnight interest rate in the narrow channel/corridor with an upper limit of ib and a lower limit of ib- 0.50 Copyright  2011 Pearson Canada Inc.

How Monetary Policy Affects the Economy I Copyright  2011 Pearson Canada Inc.

How Monetary Policy Affects the Economy II Changes in the overnight rate influences other interest rates and the exchange rate The level of short term interest rates and the exchange rate of the Canadian dollar determine the monetary conditions in which the economy operates Copyright  2011 Pearson Canada Inc.

How Monetary Policy Affects the Economy III Copyright  2011 Pearson Canada Inc.

How Monetary Policy Affects the Economy IV Copyright  2011 Pearson Canada Inc.

Nominal Interest Rates and Monetary Policy Bank of Canada uses nominal overnight interest rate as operating instrument Effects on the monetary policy on economic activity are from the real interest rate affecting consumption and investment Short term nominal rates affect short and long-term real interest rates under assumption of sticky prices Copyright  2011 Pearson Canada Inc.

Open Market Operations I Open market operations relate to the Bank of Canada selling/buying government bonds Open market purchases expand bank reserves and the monetary base, lowering interest rates and raising the money supply Open market sales reduce bank reserves and the monetary base, increasing interest rates and reducing the money supply Copyright  2011 Pearson Canada Inc.

Open Market Operations II Two Types 1. Dynamic: Meant to change MB 2. Defensive: Meant to offset other factors affecting MB The Bank conducts open market operations on government bills and bonds as the market for these instruments is most liquid and have the largest trading volume Copyright  2011 Pearson Canada Inc.

SPRAs and SRAs I In 1985, the Bank introduced repos, which in Canada are known as Special Purchase and Resale Agreements (SPRAs) In 1986, the Bank introduced reverse repos, known in Canada as Sale and Repurchase Agreements (SRAs) By 1994, the Bank stopped conducting open market operations in government of Canada T-bills and bonds and its most common operations since then have been repurchase transactions, either SPRAs of SRAs. Copyright  2011 Pearson Canada Inc.

SPRAs and SRAs II Special Purchase and Resale Agreements (SPRAs) are a tool to reduce undesired upward pressure on the overnight rate Sale and Repurchase Agreements (SRAs) are a tool to reduce undesired downward pressure on the overnight rate SPRAs and SRAs are conducted with primary dealers (formerly known as jobbers) --- the Big Six and the major investment dealers. Copyright  2011 Pearson Canada Inc.

The Bank’s Use of SPRAs to Reinforce the Target ior I If overnight funds are traded at a rate higher than the target ior, the Bank enters into SPRAs at a price that works out to the target ior. Hence, SPRAs relieve undesired upward pressure on ior Copyright  2011 Pearson Canada Inc.

The Bank’s Use of SPRAs to Reinforce the Target ior,II Bank of Canada Assets Liabilities SPRAs +100 Settlement Balances +100 Direct Clearers Assets Liabilities Settlement Balances +100 SPRAs +100 Copyright  2011 Pearson Canada Inc.

The Mechanics of a Special PRA Operation Copyright  2011 Pearson Canada Inc.

The Bank’s Use of SRAs to Reinforce the Target ior, I If overnight funds are traded at a rate below the target ior, the Bank enters into SRAs at a price that works out to the target ior. Hence, SRAs relieve undesired downward pressure on ior Copyright  2011 Pearson Canada Inc.

The Bank’s Use of SRAs to Reinforce the Target ior , II Bank of Canada Assets Liabilities Settlement Balances -100 SRAs +100 Primary Dealers Government Securities +100 Copyright  2011 Pearson Canada Inc.

Advantages of SPRAs and SRAs Bank of Canada has complete control over their volume Are flexible and precise Are easily reversed Can be implemented quickly Copyright  2011 Pearson Canada Inc.

Settlement Balances Management Bank of Canada also targets the level of settlement balances in the system Typically, target level is announced the previous day Bank neutralizes the impact on settlement balances via open-market buyback operations. Bank neutralizes SRA operations as well. Copyright  2011 Pearson Canada Inc.

Special PRA and SRA Operations Copyright  2011 Pearson Canada Inc.

Target Level of Settlement Balances Copyright  2011 Pearson Canada Inc.

Receiver General Auctions I Bank of Canada neutralizes public auctions of Receiver General balances E.g. net government receipt of $100 Bank of Canada Assets Liabilities Government Deposits -100 Settlement Balances +100 LVTS Participants Settlement Balances -100 Government Deposits +100 Copyright  2011 Pearson Canada Inc.

Receiver General Auctions II Net disbursement of $ 100 Bank of Canada Assets Liabilities Government Deposits +100 Settlement Balances -100 LVTS Participants Settlement Balances -100 Government Deposits -100 Copyright  2011 Pearson Canada Inc.

Swaps with the Exchange Fund Account Bank of Canada Assets Liabilities Foreign Exchange +100 Government Deposits +100 Government of Canada Assets Liabilities Exchange Fund Account -100 Deposits at the Bank of Canada +100 Copyright  2011 Pearson Canada Inc.

Target Level of Settlement Balances Copyright  2011 Pearson Canada Inc.

Monetary Policy at the Effective Lower Bound Conditional Statements Bank makes statements about future path of its policy rate in order to influence long-term rates Quantitative Easing purchase of financial assets by the central bank through creation of excess reserves (settlement balances) Credit Easing purchase of private sector assets by central bank in critical markets Copyright  2011 Pearson Canada Inc.

Standing Lending Facility Bank stands ready to lend (given suitable collateral) overnight settlement balances to LVTS participants with negative clearing balances. Lending rate is ib (25 points higher than target overnight rate) Large increase in demand for reserves shifts demand right and equilibrium ior increases At ib, standing lending facility puts ceiling on overnight rate (point 2) Copyright  2011 Pearson Canada Inc.

Standing Lending Facility Puts Ceiling on ior Copyright  2011 Pearson Canada Inc.

Lender of Last Resort Bank of Canada important in preventing financial panics Acts as lender of last resort. Provides emergency lending assistance (against eligible collateral) for maximum of 6 months Prevents bank failures and financial panics Copyright  2011 Pearson Canada Inc.

Discretionary Liquidity Operations Bank can be lender of last resort to entire financial system Has authority to provide liquid funds to any financial or non-financial Canadian or foreign entity to promote stability of the financial system Term PRAs Term Securities Lending Copyright  2011 Pearson Canada Inc.

Bank Advances to CPA Members 1975-2008 Copyright  2011 Pearson Canada Inc.

Advantages and Disadvantages of Bank’s Lending Policy Lender of Last Resort Role Disadvantages Financial institutions may take on more risk knowing that the Bank will provide them with advances if they get into trouble (moral hazard problem) Volume of normal advances not fully controlled by Bank Not easily reversed Copyright  2011 Pearson Canada Inc.