Chapter 17 Tools of Monetary Policy

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1 Chapter 17 Tools of Monetary Policy from Mishkin, Frederic and Apostolos SerleCs, The Economics of Money, Banking and Financial Markets 4 th Canadian EdiCon, Pearson Canada Copyright 2011 Pearson Canada Inc. 17-1

2 The Large Value Transfer System (LVTS) I The LVTS (introduced in 1999) electronic, real- Cme net seolement network designed to provide immediate finality and seolement to Cme- criccal transaccons LVTS parccipants know in real Cme their large- value, wholesale transaccons (over $50,000). TransacCons account for < 1% of the total number of transaccons They make up 94% of the value of transaccons in Canada Copyright 2011 Pearson Canada Inc. 17-2

3 The Large Value Transfer System (LVTS) II The LVTS uses mulclateral neyng only the net credit or debit posicon of each parccipant vis- à- vis all other parccipants is calculated for seolement Copyright 2011 Pearson Canada Inc. 17-3

4 The OperaCng Band for the Overnight Interest Rate I The interest rate at which parccipants 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. 17-4

5 The OperaCng Band for the Overnight Interest Rate II The Bank s objeccve 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 operacng band Copyright 2011 Pearson Canada Inc. 17-5

7 The Bank s Standing Liquidity FaciliCes I At the end of each day, each LVTS parccipant must bring its seolement balance with the Bank close to zero. The Bank therefore stands ready (standing facilices) to provide or absorb liquidity with an overnight duracon to parccipants facing unforeseen liquidity shocks. Copyright 2011 Pearson Canada Inc. 17-7

8 The Bank s Standing Liquidity FaciliCes II The inicacve is on the side of the LVTS parccipant. A parccipant 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. 17-8

9 The Bank of Canada and the OperaCng band If the overnight rate increases toward the upper limit of the operacng 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 operacng band, then the Bank will accept deposits from LVTS parccipants at the bank rate less 50 basis points puyng a floor on the overnight rate Copyright 2011 Pearson Canada Inc. 17-9

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

11 Supply Curve Supply Curve for Reserves quancty of reserves supplied is infinitely elascc at i b Also flat at i b because banks would not lend in the overnight market Between i b 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

12 The Channel/Corridor System for the Overnight Rate In terms of Figure 17-2, the equilibrium interest rate will always be within the operacng band 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 Copyright 2011 Pearson Canada Inc

15 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 condicons in which the economy operates Copyright 2011 Pearson Canada Inc

18 Nominal Interest Rates and Monetary Policy Bank of Canada uses nominal overnight interest rate as operacng instrument Effects on the monetary policy on economic accvity are from the real interest rate affeccng consumpcon and investment Short term nominal rates affect short and long- term real interest rates (expectacon theory of the term structure of interest rates) Copyright 2011 Pearson Canada Inc

19 Open Market OperaCons Open market operacons 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

20 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 conduccng open market operacons in government of Canada T- bills and bonds and its most common operacons since then have been repurchase transaccons, either SPRAs of SRAs. Copyright 2011 Pearson Canada Inc

21 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

22 The Bank s Use of SPRAs to Reinforce the Target i or I 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 Copyright 2011 Pearson Canada Inc

23 The Bank s Use of SPRAs to Reinforce the Target i or, II Bank of Canada Assets LiabiliCes SPRAs +100 SeOlement Balances +100 Direct Clearers Assets LiabiliCes SeOlement Balances +100 SPRAs +100 Copyright 2011 Pearson Canada Inc

25 The Bank s Use of SRAs to Reinforce the Target i or, I 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 Copyright 2011 Pearson Canada Inc

26 The Bank s Use of SRAs to Reinforce the Target i or, II Bank of Canada Assets LiabiliCes SeOlement Balances SRAs +100 Primary Dealers Assets LiabiliCes SeOlement Balances Government SecuriCes +100 Copyright 2011 Pearson Canada Inc

27 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 Copyright 2011 Pearson Canada Inc

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

31 Transferring Government Deposits I: * From Bank of Canada and into the Chartered Banks Bank of Canada Assets LiabiliCes Government Deposits SeOlement Balances +100 LVTS ParCcipants Assets LiabiliCes SeOlement Balances +100 Government Deposits +100 Copyright 2011 Pearson Canada Inc

32 Transferring Government Deposits II: * From the Chartered Banks (LVTS) and into Bank of Canada Bank of Canada Assets LVTS ParCcipants LiabiliCes Government Deposits +100 SeOlement Balances Assets SeOlement Balances LiabiliCes Government Deposits Copyright 2011 Pearson Canada Inc

33 Standing Lending Facility Bank stands ready to lend (given suitable collateral) overnight seolement balances to LVTS parccipants with negacve clearing balances. Lending rate is i b (25 points higher than target overnight rate) Large increase in demand for reserves shirs demand right and equilibrium i or increases At i b, standing lending facility puts ceiling on overnight rate (point 2) Copyright 2011 Pearson Canada Inc

35 Lender of Last Resort Bank of Canada important in prevencng 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

36 DiscreConary Liquidity OperaCons Bank can be lender of last resort to encre financial system Has authority to provide liquid funds to any financial or non- financial Canadian or foreign encty to promote stability of the financial system Term PRAs Term SecuriCes Lending Copyright 2011 Pearson Canada Inc

38 Advantages and Disadvantages of Bank s Lending Policy Advantages Lender of Last Resort Role Disadvantages Financial insctucons 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

39 Monetary Policy at the EffecCve Lower Bound CondiConal Statements Bank makes statements about future path of its policy rate in order to influence long- term rates QuanCtaCve Easing purchase of financial assets by the central bank through creacon of excess reserves (seolement balances) Credit Easing purchase of private sector assets by central bank in criccal markets Copyright 2011 Pearson Canada Inc

Before discussing these, lets understand the concept of overnight interest rate.

Before discussing these, lets understand the concept of overnight interest rate. LECTURE 8 Hamza Ali Malik Econ 3215: Money and Banking Winter 2007 Chapter # 17: Tools of Monetary Policy There are at least three tools that the Bank of Canada can use to manipulate market interest rates