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 and the money supply: i) Open Market Operations ii) Bank of Canada Advances iii) Government Deposit Shifting Before discussing these, lets understand the concept of overnight interest rate. The Overnight Interest Rate This is the interest rate at which participants borrow and lend overnight funds to each other in the money market. This rate is the shortest-term rate available and forms the basis of any term structure of interest rates and monetary policy. The operating band of 50 basis point (1/2 of 1%) for the overnight interest rate. i b i b - 0.50 50 basis-pt. operating band Deficit (overdraft) 0 Surplus 1
The upper limit defines the bank rate the rate the Bank of Canada charges LVTS participants that require an overdraft loan to cover negative settlement balances. The lower limit is the rate the Bank pays to LVTS participants with positive settlement balances. LVTS participants can make a payment only if they have, in real time (right now), either positive settlement balances in their accounts with the Bank, or posted collateral (such as government of Canada Treasury bills and bonds), or explicit lines of credit with other participants. 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 (standing facility) to lend at i b or borrow at i b less 50 basis points, to bring settlement balances to zero at the end of the banking day. The Equilibrium Overnight Rate Demand Curve for Settlement Balances At i b, the demand curve is horizontal. At i b less 50 basis point, the demand curve is also horizontal. At rates within the band, the demand for settlement balances is zero. 2
Supply Curve for Settlement Balances Bank normally targets a daily level of settlement balances of zero. Supply curve is a vertical line at the zero quantity. Market Equilibrium Occurs at the intersection of the vertical supply curve and the vertical part of the demand curve at the zero quantity. Equilibrium i or could be anywhere within the operating band. Open Market Operations Two Types: 1) Dynamic meant to change MB. 2) Defensive meant to offset other factor affecting MB; typically uses SPRAs & SRAs. Advantages 1) Bank has complete control. 2) Flexible and precise. 3) Easily reversed. 4) Implemented quickly. The Bank s use of SPRAs If overnight funds are traded at a rate higher than the target rate; the Bank enters into SPRAs, at a price that works out to the target i OR. 3
Bank of Canada SPRAs +100 Settlement Balances +100 Direct Clearers Settlement Balances +100 SPRAs +100 Hence, SPRAs relieve undesired upward pressure on i OR. The Bank s use of SRAs If overnight funds are traded at a rate below the target rate, the Bank enters into SRAs, at a price that works out to the target i OR. Bank of Canada Settlement Balances -100 SRAs +100 Direct Clearers Settlement Balances -100 SRAs +100 Hence, SRAs alleviate undesired downward pressure on i OR. 4
Bank of Canada Lending (Advances) Two types: 1) Standing Liquidity Facility; to reinforce the operating band for i OR. 2) Last Resort Lending. Advantage: Lender of Last Resort role is used to prevent banking panics and non-bank financial panics. Disadvantages: 1) Confusion interpreting bank rate changes. 2) Fluctuations in advances cause unintended fluctuations in M s. 3) Not fully controlled by Bank. Proposed Reforms 1) Abolish central bank lending. Eliminates fluctuations in M s. However, lose lender of last resort role. 2) Tie bank rate to market rate. i - i b = constant, so fewer fluctuations of A and M s. Easier administration. No false announcement signals. 5
Government Deposit Shifting: Neutralizing a Net Government Receipt Consider a net government receipt of $100 (i.e., the government s receipts from the public exceed its payments to the public by $100). To prevent a in settlement balances and an increase in i OR, the Bank of Canada neutralizes the net government receipt by a transfer of $100 from the government s account at the Bank to the government s account at the LVTS participants. Bank of Canada Government Deposits -100 Settlement Balances +100 Direct Clearers Settlement Balances +100 Government Deposits +100 The Framework for the Implementation of M.P In schematic terms the general approach to policy in most countries can be characterized as follows (details are discussed in handout 3): Instrument(s) Operational target Indicators / information variables (OMOs, bank rate, (short-term interest rate, MCI) (e.g., certain interest rate spreads) deposit switching) Intermediate target Ultimate target (monetary aggregates, (price stability) rate of growth of GDP) 6
Monetary Policy Strategy Discretion Constrained Discretion Based on Rules Discretion Broad mandate in terms of ultimate policy objectives. Typically multiplicity of objectives. For example, price stability, high employment, external balance, financial stability. Monetary authority free to choose operational procedures. Central bank not necessarily independent from government. Constrained Discretion Mandate set by law or government decision. Specifics of mandate may or may not be determined by the central bank. Examples: Inflation target (hard or soft), flexible monetary target. Monetary authority free to choose operational procedures. Central bank normally independent from government. Based on Rules Central bank determines changes in its operational instrument, normally a short-term interest rate, by means of a specific rule. Examples: Gold standard or other fixed exchange rate arrangement. 7
Feedback rule such as interest rate based Taylor rule. Rule-based monetary targets. Choice Between Discretion and Rules Central banks normally favour discretion or constrained discretion, while many academics call for rules-based monetary policies. Advantages of Rules Commitment to sensible ultimate policy objectives: Price stability as principal policy objective; limited scope for stabilization of output and employment (because attempting to stabilize output/employment can distort price stability objective). Rules promote transparency of monetary policy to the public and strengthen credibility of central bank. Disadvantages of Rules May prevent central banks from reacting appropriately to unexpected shocks. If rules are complicated, they may be hard to understand by the public and fail to enhance transparency. Taylor Rule, NAIRU, and the Phillips Curve Taylor Rule: How the target i OR is chosen? Overnight rate = equilibrium real overnight rate + inflation + 1/2 (inflation gap) + 1/2 (output gap) 8
The presence of both an inflation gap and an output gap in the Taylor rule indicates that the Bank cares not only about keeping inflation (π) low but also about minimizing business cycle fluctuations of output (y) around its potential. This is consistent with many statements of Bank officials that controlling π and stabilizing y are important concerns of the Bank. Alternatively: i OR 1 ( π π ) + ( y ) 1 = ror + π + y 2 2 where, i stands for nominal interest rate, r stands for real interest rate, target inflation rate, and can write: i OR y is the target output level. Since 1 ( π π ) + ( y ) 3 = ior + y 2 2 π is the i = r + π by definition, The important point to note is that the coefficient in front of the inflation gap term is greater than one. This ensures that the nominal interest rate changes has a desired effect on the economy. Example: Suppose that the equilibrium real overnight rate is 2%, that π* = 2% and π = 3%, leading to a positive inflation gap of π - π* = 1% (= 3% - 2%). Also assume that real GDP is 1% above its potential, resulting in a positive output gap of 1%. Then the Taylor rule suggests that the overnight rate should be set at: i OR = 2% + 3% + ½ (1% inflation gap) +1/2 (1% output gap) = 6%. 9
Phillips Curve --- relationship between inflation and output gap π = π + λ t e t ( y t y) + v t An alternative interpretation of the presence of the output gap in the Taylor rule is that the output gap is an indicator of future π, as stipulated in Phillips curve theory. This theory indicates that changes in π are influenced by the state of the economy relative to its productive capacity, measured by potential GDP which is a function of the natural rate of unemployment. A related concept is the NAIRU, the non-accelerating inflation rate of unemployment (the u at which π = 0). When u > NAIRU, with GDP < potential GDP, π will When u < NAIRU, with GDP > potential GDP, π will 10