1. Tools of Monetary Policy
Chapter 17
Tools of Monetary Policy
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2. 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
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3. 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
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4. 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
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5. 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
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6. 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
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7. 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
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8. The Operating Band for the Overnight Interest Rate III
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9. 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.
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10. 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.
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11. 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
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12. 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
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13. The Channel/Corridor System for the Overnight Rate
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14. 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
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15. Supply Curve for Reserves
quantity of reserves supplied is infinitely elastic at ib
Also flat at ib because banks would not ledn in the overnight market
Between ib and ib, banks will not borrow from the Bank and borrowed reserves (BR) equal zero (cheaper to borrow in overnight market)
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16. 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
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17. How Monetary Policy Affects the Economy I
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18. 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
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19. How Monetary Policy Affects the Economy III
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20. How Monetary Policy Affects the Economy IV
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21. 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
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22. 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
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23. 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
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24. 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.
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25. 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.
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26. 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
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27. The Bank’s Use of SPRAs to Reinforce the Target ior,II
Bank of Canada
Assets Liabilities
SPRAs Settlement Balances +100
Direct Clearers
Assets Liabilities
Settlement Balances SPRAs +100
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28. The Mechanics of a Special PRA Operation
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29. 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
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30. The Bank’s Use of SRAs to Reinforce the Target ior , II
Bank of Canada
Assets Liabilities
Settlement Balances -100
SRAs
Primary Dealers
Government Securities +100
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31. 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
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32. 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.
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33. Special PRA and SRA Operations
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34. Target Level of Settlement Balances
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35. 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 Government Deposits +100
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36. Receiver General Auctions II
Net disbursement of $ 100
Bank of Canada
Assets Liabilities
Government Deposits +100
Settlement Balances
LVTS Participants
Settlement Balances Government Deposits -100
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37. Swaps with the Exchange Fund Account
Bank of Canada
Assets Liabilities
Foreign Exchange Government Deposits +100
Government of Canada
Assets Liabilities
Exchange Fund Account -100
Deposits at the Bank of Canada +100
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38. Target Level of Settlement Balances
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39. 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
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40. 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)
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41. Standing Lending Facility Puts Ceiling on ior
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42. 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
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43. 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
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44. Bank Advances to CPA Members 1975-2008
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45. 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
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