1. © 2008 Pearson Education Canada17.1 Chapter 17 Tools of Monetary Policy

2. © 2008 Pearson Education Canada17.2 Overview So far we derived a multiplicative relation between the money supply and the monetary base Discussed three monetary policy tools that the Bank of Canada can use to manipulate i and M. These tools are open market operations Bank of Canada advances, and government deposit shifting

3. © 2008 Pearson Education Canada17.3 Overview (Cont’d) In recent years, however, the Bank conducts policy by setting an operating band for the overnight interest rate i or and targeting i or at the midpoint of the band. In doing so, the Bank permits M to do whatever necessary to keep i or on target.

4. © 2008 Pearson Education Canada17.4 The Large Value Transfer System (LVTS) The LVTS (introduced in 1999) is an 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). Although these transactions account for less than 1% of the total number of transactions, they account for about 94% of the value of transactions in Canada

5. © 2008 Pearson Education Canada17.5 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

6. © 2008 Pearson Education Canada17.6 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

7. © 2008 Pearson Education Canada17.7 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

8. © 2008 Pearson Education Canada17.8 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

9. © 2008 Pearson Education Canada17.9 Direct Clearers The subset of LVTS participants who participate directly in the ACSS and are known as direct clearers

10. © 2008 Pearson Education Canada17.10 The Operating Band for the Overnight Interest Rate 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.

11. © 2008 Pearson Education Canada17.11 Such changes influence other short-term interest rates and the exchange rate

12. © 2008 Pearson Education Canada17.12 The Operating Band for the Overnight Interest Rate (Cont’d) 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

13. © 2008 Pearson Education Canada17.13 The Operating Band for the Overnight Interest Rate (Cont’d)

14. © 2008 Pearson Education Canada17.14 The Bank’s Standing Liquidity Facilities 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 (we call this standing facilities) to provide or absorb liquidity with an overnight duration to participants facing unforeseen liquidity shocks.

15. © 2008 Pearson Education Canada17.15 The Bank’s Standing Liquidity Facilities (Cont’d) 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.

16. © 2008 Pearson Education Canada17.16 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

17. © 2008 Pearson Education Canada17.17 The Channel/Corridor System for the Overnight Rate The system enables the Bank to keep the overnight interest rate in the narrow channel / corridor with an upper limit of i b and a lower limit of i b - 0.50

18. © 2008 Pearson Education Canada17.18 How Monetary Policy Affects the Economy

19. © 2008 Pearson Education Canada17.19 How Monetary Policy Affects the Economy (Cont’d) 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

20. © 2008 Pearson Education Canada17.20 How Monetary Policy Affects the Economy (Cont’d)

21. © 2008 Pearson Education Canada17.21 How Monetary Policy Affects the Economy (Cont’d)

22. © 2008 Pearson Education Canada17.22 Open Market Operations 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

23. © 2008 Pearson Education Canada17.23 Open market sales reduce bank reserves and the monetary base, increasing interest rates and reducing the money supply

24. © 2008 Pearson Education Canada17.24 Open Market Operations (Cont’d) 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

25. © 2008 Pearson Education Canada17.25 SPRAs and SRAs 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)

26. © 2008 Pearson Education Canada17.26 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. See Table 9.1 of textbook which shows balance sheets of the chartered banks with the liabilities called ‘obligations related to sales sold under repos’

27. © 2008 Pearson Education Canada17.27 SPRAs and SRAs (Cont’d) SPRAs and SRAs are conducted with primary dealers (formerly known as jobbers) --- the Big Six and the major investment dealers. 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

28. © 2008 Pearson Education Canada17.28 The Bank’s Use of SPRAs to Reinforce the Target i or 1.If overnight funds are traded at a rate higher than the target i or, the Bank enters into SPRAs at a price that works out to the target i or. 2. Hence, SPRAs relieve undesired upward pressure on i or

29. © 2008 Pearson Education Canada17.29 The Bank’s Use of SRAs to Reinforce the Target i or 1.If overnight funds are traded at a rate below the target i or, the Bank enters into SRAs at a price that works out to the target i or. 2. Hence, SRAs relieve undesired downward pressure on i or

30. © 2008 Pearson Education Canada17.30 Advantages of SPRAs and SRAs 1.Bank of Canada has complete control over their volume 2.Are flexible and precise 3.Are easily reversed 4.Can be implemented quickly

31. © 2008 Pearson Education Canada17.31 Bank of Canada (Advances) Standing Liquidity Facility, to reinforce the operating band for i or Last Resort Lending Lender of Last Resort Function To prevent financial panics CDIC fund not big enough

32. © 2008 Pearson Education Canada17.32 Lending Policy Advantages 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

33. © 2008 Pearson Education Canada17.33 Government Deposit Shifting Prior to the introduction of the LVTS, management of settlement balances (cash setting) was the main mechanism by which the Bank of Canada implemented monetary policy.

34. © 2008 Pearson Education Canada17.34 In particular, using drawdowns (transfers of government deposits from the direct clearers to the Bank of Canada) and redeposits (transfers of government deposits from the Bank of Canada to the direct clearers), the Bank was essentially implementing its target band for the overnight interest rate.

35. © 2008 Pearson Education Canada17.35 Swaps With the Exchange Fund Account (EFA) The Bank usually brings onto its balance sheet EFA assets to back its liabilities. It does so by arranging a swap with the Exchange Fund Account (EFA). If the Bank temporarily buys $100 of FX from the EFA – see next slide

36. © 2008 Pearson Education Canada17.36 Swaps With the Exchange Fund Account (EFA) (Cont’d) Bank of Canada Assets Liabilities Foreign exchange +100Government Deposits + 100 Government of Canada Assets Liabilities EFA -100 Deposits at the Bank +100 Government deposits at the Bank  and now can be transferred to banks to  settlement balances.

37. © 2008 Pearson Education Canada17.37 An Example of Monetary Control Suppose that the operating band is 4.5% to 5% and the Bank wishes to tighten policy by raising the band by 25 basis points In one of the eight fixed days for announcing changes to the band for i or, the Bank announces, at 9:00 a.m., that it is adjusting the band up from 4.5% to 5% to 4.75% to 5.25%

38. © 2008 Pearson Education Canada17.38 An Example of Monetary Control (Cont’d) From this announcement, LVTS participants know that the i b shifts from 5% to 5.25%, the rate on positive settlement balances shifts from 4.5% to 4.75%, and that the Bank’s new target i or, the midpoint of the operating band, shifts from 4.75% to 5%

39. © 2008 Pearson Education Canada17.39 If later in the day overnight funds are trading below the target i or, the Bank enters into SRAs to enforce the new target for i or

40. © 2008 Pearson Education Canada17.40 Monetary Policy of the Federal Reserve in U.S. the institutional arrangements and the mechanism are quite than Canada

41. © 2008 Pearson Education Canada17.41 Monetary Policy of the Federal Reserve in U.S Open market operations –Affect the quantity of reserves and the monetary base Discount lending –Affect the monetary base Changes in reserve requirements –Affect the money multiplier Federal funds rate (i ff ) - the interest rate on overnight loans of reserves from one bank to another –Primary indicator of the stance of monetary policy

42. © 2008 Pearson Education Canada17.42 The Market for Reserves Two components: non-borrowed and borrowed reserves Cost of borrowing from the Fed is the discount rate (i d ) Borrowing from the Fed is a substitute for borrowing from other banks If i ff < i d, then banks will not borrow from the Fed and borrowed reserves are zero

43. © 2008 Pearson Education Canada17.43 The supply curve will be vertical (assumes a closed economy) As i ff rises above i d, banks will borrow more and more at i d, and re-lend at i ff The supply curve is horizontal (perfectly elastic) at i d

44. © 2008 Pearson Education Canada17.44 The Market for Reserves

45. © 2008 Pearson Education Canada17.45 Open Market Operations An open market purchase causes the federal funds rate to fall; an open market sale causes the federal funds rate to rise  shifting the supply curve If the intersection of supply and demand occurs on the vertical section of the supply curve, a change in the discount rate will have no effect on the federal funds rate

46. © 2008 Pearson Education Canada17.46 Open Market Operations (Cont’d)

47. © 2008 Pearson Education Canada17.47 Discount Lending

48. © 2008 Pearson Education Canada17.48 Reserve Requirements

49. © 2008 Pearson Education Canada17.49 Monetary Policy Tools of the European Central Bank Read on your own