1. Copyright © 2014 Pearson Canada Inc. Chapter 17 TOOLS OF MONETARY POLICY Mishkin/Serletis The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition

2. Copyright © 2014 Pearson Canada Inc. 17-2 Learning Objectives 1.Characterize the framework for the implementation of monetary policy in Canada 2.Explain the market for reserves and the channel/corridor system for setting the overnight interest rate in Canada 3.Identify the Bank of Canada’s approach to monetary policy and the conventional and nonconventional tools of monetary policy 4.Explain how the Federal Reserve and the European Central Bank can use their policy tools to manipulate interest rates and the money supply

3. Copyright © 2014 Pearson Canada Inc. 17-3 The Large Value Transfer System (LVTS) LVTS –electronic, real-time net settlement network –designed to provide immediate finality and settlement to time-critical transactions –put in place in order to eliminate systemic risk 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

4. Copyright © 2014 Pearson Canada Inc. 17-4 The Large Value Transfer System (cont’d) 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

5. Copyright © 2014 Pearson Canada Inc. 17-5 Systemic Risk The risk to the entire payments system due to the inability of one financial institution to fulfill its payment obligations The LVTS has been put in place to eliminate systemic risk 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

6. Copyright © 2014 Pearson Canada Inc. 17-6 Non-LVTS (ACSS) 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

7. Copyright © 2014 Pearson Canada Inc. 17-7 The Bank of Canada’s Policy Rate Overnight interest rate –It is the interest rate at which participants borrow and lend overnight funds to each other in the money market. The reference rate –The Bank of Canada signals its monetary policy stance by announcing a target for the overnight interest rate. –The overnight interest rate is known as the reference rate. The policy rate –The target for the overnight rate, known as the policy rate, is the main tool the Bank uses to conduct monetary policy.

8. Copyright © 2014 Pearson Canada Inc. 17-8 The Operating Band for the Overnight Interest Rate The Bank’s objective is to keep the overnight rate within a band of 50 basis points (1/2 of 1%) In response to the subprime financial crisis, the Bank of Canada temporarily narrowed the operating band for the overnight interest rate to 25 basis points (1/4 of 1%) The Bank operates under a system of eight “fixed” dates throughout the year for announcing changes to the operating band

9. Copyright © 2014 Pearson Canada Inc. 17-9 Operating Band for the Overnight Interest Rate

10. Copyright © 2014 Pearson Canada Inc. 17-10 The Bank of Canada's Standing Facilities At the end of each banking day, each LVTS participant must bring its settlement balance with the Bank close to zero The Bank of Canada therefore stands ready (with standing liquidity facilities) to lend to or borrow from a participant to bring their settlement balances to zero at the end of the banking day Participants know with certainty the rates applicable to positive and negative settlement balances

11. Copyright © 2014 Pearson Canada Inc. 17-11 The Bank of Canada's Standing Facilities (cont’d) The initiative is on the side of the LVTS participant – participant may use the Bank’s lending facility to obtain overnight liquidity in case of a shortage, or –participant may use the deposit facility to make deposits in case of excess liquidity

12. Copyright © 2014 Pearson Canada Inc. 17-12 The Bank of Canada and the Operating Band If the overnight rate increases toward the upper limit of the operating band –the Bank will lend at the bank rate –puts a ceiling on the overnight rate If the overnight rate falls toward the lower limit of the operating band –the Bank will accept deposits from LVTS participants at the bank rate less 50 basis points –puts a floor on the overnight rate

13. Copyright © 2014 Pearson Canada Inc. 17-13 The Market for Settlement Balances The market for settlement balances (reserves) is where the overnight interest rate is determined Market for reserves can be described in a symmetric channel/corridor system of interest-rate control Demand and Supply in the Market for Reserves Market equilibrium where the quantity of reserves demanded equals the quantity of reserves supplied determines the overnight rate

14. Copyright © 2014 Pearson Canada Inc. 17-14 Equilibrium in the Market for Reserves

15. Copyright © 2014 Pearson Canada Inc. 17-15 Demand Curve When the overnight rate is above the interest rate paid on excess reserves, i er : –the overnight rate decreases –the opportunity cost of holding excess reserves falls –the quantity of reserves demanded rises When the overnight rate is below the interest rate paid on excess reserves i er : –banks keep on adding to their holdings of excess reserves indefinitely Downward sloping demand curve becomes flat (infinitely elastic) at i er

16. Copyright © 2014 Pearson Canada Inc. 17-16 Supply Curve Two components: non-borrowed (NBR) and borrowed reserves (BR) Cost of borrowing from the Bank of Canada is the bank rate (i b ) Borrowing from the Bank of Canada is a substitute for borrowing from other banks If i or < i b, then banks will not borrow from the Bank of Canada and borrowed reserves are zero The supply curve will be vertical As i or rises above i b, banks will borrow more and more at i b, and re-lend at i or The supply curve is horizontal (perfectly elastic) at i b

17. Copyright © 2014 Pearson Canada Inc. 17-17 How the Bank of Canada’s Operating Procedures Limit Fluctuations in the Overnight Interest Rate If the equilibrium overnight interest rate is at the overnight rate target of i* If the demand for reserves has a large unexpected increase, the demand curve would shift to the right to R d2, where it now intersects the supply curve for reserves on the flat portion where the equilibrium overnight rate i 2 = i b The Bank of Canada’s operating procedures limit the fluctuations of the overnight interest rate to between i er = i b - 0.50 and i b

18. Copyright © 2014 Pearson Canada Inc. 17-18 How the Bank of Canada’s Operating Procedures Limit Fluctuations in the Overnight Interest Rate

19. Copyright © 2014 Pearson Canada Inc. 17-19 Inflation Rates and Inflation Targets for Canada

20. Copyright © 2014 Pearson Canada Inc. 17-20 How Monetary Policy Affects the Economy 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

21. Copyright © 2014 Pearson Canada Inc. 17-21 How the Bank of Canada Keeps the Rate of Inflation from Falling Below the Target Range

22. Copyright © 2014 Pearson Canada Inc. 17-22 How the Bank of Canada Keeps the Rate of Inflation from Moving Above the Target Range

23. Copyright © 2014 Pearson Canada Inc. 17-23 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