Transcript Chapter 17 - Pearson Canada

chapter 17
The Framework for the
Implementation of Monetary
Policy and the Tools of Monetary
Policy
Overview
So far we derived a multiplicative relation between M and MB
M = m  MB
and 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
In recent years, however, the Bank conducts policy by setting
an operating band for the overnight interest rate ior and
targeting ior at the midpoint of the band. In doing so, the
Bank permits M to do whatever necessary to keep ior on
target.
Copyright © 2002 Pearson Education Canada Inc.
17- 2
The Role of Money
Before we go on, we have to clear up a potential confusion:
Although the Bank of Canada can control both i and M, it
would be wrong to view i and M as distinct policy
instruments. The reason is that a given i policy has to be
supported by a given M policy. That is, the Bank
influences i by adjusting M. To put it differently, i is the
price of M and the Bank affects the price of M (that is,
the interest rate) by controlling the quantity of money.
With this in mind, let’s discuss the institutional framework
within which the Bank conducts monetary policy.
Copyright © 2002 Pearson Education Canada Inc.
17- 3
The Large Value Transfer System,
LVTS
•
•
•
The LVTS (introduced on February 4, 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
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
Copyright © 2002 Pearson Education Canada Inc.
17- 4
LVTS Participants
As of January 2001, in addition to the Bank of Canada, there
were 13 LVTS participants — members of the CPA who
participate in the LVTS and maintain a settlement
account at the Bank of Canada. These are:
Big Six
Alberta Treasury Branches
Bank of America Canada
Banque Nationale de Paris Canada
La Caisse centrale Desjardins du Québec
Credit Union Central of Canada
HSBC Bank Canada
Laurentian Bank of Canada
Copyright © 2002 Pearson Education Canada Inc.
17- 5
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
Copyright © 2002 Pearson Education Canada Inc.
17- 6
Real-Time Settlement Systems in
Other Countries
The LVTS has been put in place in order to eliminate
systemic risk — the risk to the entire payments system
due to the inability of one bank to fulfill its payment
obligations in a timely fashion. Of, course it is not just
Canada that is concerned about systemic risk.
Country
U.S. (Fedwire)
Sweden
Germany and Switzerland
Japan
Italy
Belgium and U.K.
France, Hong Kong, and Netherlands
Copyright © 2002 Pearson Education Canada Inc.
Year introduced
1918
1986
1987
1988
1989
1996
1997
17- 7
Small Value Transactions
and the ACSS
•
•
•
•
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
The Bank of Canada completes the settlement
retroactively the next day (at midday) through the LVTS
Copyright © 2002 Pearson Education Canada Inc.
17- 8
Direct and Indirect Clearers
Direct Clearers:
• The subset of LVTS participants who participate directly
in the ACSS and are known as direct clearers
Indirect Clearers:
• These are the deposit-taking financial institutions that are
members of the CPA but do not have a clearing account
with the Bank of Canada.
• Indirect clearers hold deposits in direct clearers in
exchange for a variety of services, including cheque
clearing, foreign exchange transactions, and help with
securities purchases
Copyright © 2002 Pearson Education Canada Inc.
17- 9
The Operating Band of 50 Basis Points
for the Overnight Interest Rate
The upper limit defines
the bank rate — the rate
the Bank 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
Copyright © 2002 Pearson Education Canada Inc.
17- 10
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 liquidity
facilities) to provide or absorb liquidity with an overnight
duration to participants facing unforeseen liquidity shocks.
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.
Copyright © 2002 Pearson Education Canada Inc.
17- 11
The Bank’s Standing Liquidity
Facilities (continued)
Although the Bank’s standing facilities provide an insurance
mechanism for banks, they do so at penalty rates:
• Regarding LVTS settlements, the Bank charges ib on LVTS
collateralized advances and pays ib less 50 basis points on
LVTS positive balances.
• Regarding ACSS settlements, the Bank charges ib plus 150
basis points on ACSS collateralized advances and pays ib
less 150 basis points on ACSS positive balances.
So the rate spread at the Bank’s standing facilities for ACSS
balances is 250 basis points wider than for LVTS balances.
Copyright © 2002 Pearson Education Canada Inc.
17- 12
Pre-settlement Trading
Participants can reduce the costs of either positive or negative
positions by trading with each other in the LVTS presettlement period at the end of the day (6:00-6:30 p.m.).
In fact, the typical bid-ask spread on overnight funds in the
interbank market has been less than 1/8%, much less than
the 50 basis points on LVTS balances and 300 basis points
on ACSS balances.
Hence, participants can adjust positions with each other in the
overnight market at a better return than can be achieved at
the Bank’s standing facilities.
Copyright © 2002 Pearson Education Canada Inc.
17- 13
The Market Timetable
Copyright © 2002 Pearson Education Canada Inc.
17- 14
The Bank’s Implementation of the
Operating Band for ior
If ior  towards the upper
limit, then the Bank will
lend at ib to put a ceiling
on ior
If ior  towards the lower
limit, then the Bank will
accept deposits at ib less
50 basis points, to put a
floor on ior
Copyright © 2002 Pearson Education Canada Inc.
17- 15
The Market for Settlement
Balances and ior
Demand Curve for Settlement Balances
1. At ib, the demand curve is horizontal, since the demand for negative
settlement balances will be indefinitely large
2. At ib less 50 basis points, the demand curve is also horizontal, since the
demand for positive settlement balances would also be indefinitely
large
3. At rates within the band, the demand for settlement balances is zero
Supply Curve for Settlement Balances
1. Bank normally targets a daily level of settlement balances of zero
2. Supply curve is a vertical line at the zero quantity
Market Equilibrium
1.
2.
Occurs at the intersection of the vertical supply curve and the vertical
part of the demand curve at the zero quantity
Equilibrium ior could be anywhere within the operating band
Copyright © 2002 Pearson Education Canada Inc.
17- 16
Supply and Demand for
Settlement Balances
The equilibrium ior is
indeterminate and
could be anywhere
within the 50-basispoint band.
This means that the
actual ior will be
somewhat different
from the target ior
indicated at the start
of the banking day
by the Bank.
Copyright © 2002 Pearson Education Canada Inc.
17- 17
The Bank’s Current Approach to
Monetary Policy
In February 1991, the Bank’s
governor and the minister of
finance announced a series of
declining  targets. The
targets were 3% by the end of
1992, falling to 2% by the end
of 1995, to remain within a
range of 1%-3% thereafter.
The 1%-3% target range for 
was renewed in December
1995, in early 1998, and again
in May 2001, to apply until the
end of 2006.
The goal of the Bank’s current
policy is to keep  at the
midpoint of the  target range,
2%.
Copyright © 2002 Pearson Education Canada Inc.
17- 18
How the Bank Keeps  From
Falling Below the Target Range
The Bank expects
the economy to
slow down and
wishes to ease
monetary
conditions.
It lowers the
operating band for
ior, thereby
encouraging banks
to borrow R either
from each other at
ior or from the
Bank at ib
Copyright © 2002 Pearson Education Canada Inc.
E 
euro
$
The  in i and E lead to an  in
M, AD, and P, thereby
preventing  from falling
below the target range.
17- 19
How the Bank Keeps  From
Moving Above the Target Range
E
The Bank expects
the economy to be
exceeding its
capacity in the
future and wishes
to slow it down.
euro
$
The  in i and E lead to an  in M, AD,
and P, thereby preventing  from
moving above the target range.
It raises the
operating band for
ior in order to
prevent
inflationary
pressures from
building.
Copyright © 2002 Pearson Education Canada Inc.
17- 20
The Bank’s Influence on
Long-Term Interest Rates
By changing the operating band for ior the Bank sends a signal
regarding the direction that it would like i and M to take.
•A rise in the band and thus ib is a signal that the Bank would like
to see  i and  M in the economy.
•A fall in the band is a signal that the Bank would like  i and  M.
However, the Bank’s direct influence on long-term rates diminishes as
the time period . Long-term rates can be either higher or lower than
short-term rates depending on expectations about  and the level of
short-term rates in the future, the relative balance between the demand
for and supply of loanable funds, the level of i in the U. S., and the
relative stance of monetary policies in the two countries.
Copyright © 2002 Pearson Education Canada Inc.
17- 21
Open Market Operations
Two Types
1. Dynamic:
Meant to change MB
2. Defensive:
Meant to offset other factors affecting MB
Advantages of Open Market Operations
1. Bank has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly
Copyright © 2002 Pearson Education Canada Inc.
17- 22
SPRAs and SRAs
Over the years, the Bank introduced additional tools in its conduct
of monetary policy.
1. In 1985, the Bank introduced repos, which in Canada are
known as Special Purchase and Resale Agreements
(SPRAs)
2. 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.
Copyright © 2002 Pearson Education Canada Inc.
SPRAs and SRAs, are conducted with primary
dealers (formerly known as jobbers) — the Big
Six and the major investment dealers.
17- 23
The Bank’s Use of SPRAs to
Reinforce the Target ior
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.
Bank of Canada
Assets
SPRAs +100
Liabilities
Settlement Balances +100
Direct Clearers
Assets
Settlement Balances +100
Liabilities
SPRAs +100
Hence, SPRAs relieve undesired upward pressure on ior
Copyright © 2002 Pearson Education Canada Inc.
17- 24
The Bank’s Use of SRAs to
Reinforce the Target ior
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 ior
Bank of Canada
Assets
Direct Clearers
Assets
Settlement Balances -100
SRAs
+100
Liabilities
Settlement Balances - 100
SRAs
+100
Liabilities
Hence, SRAs alleviate undesired downward pressure on ior
Copyright © 2002 Pearson Education Canada Inc.
17- 25
Bank of Canada Lending
(Advances)
Two Types
1. Standing Liquidity Facility, to reinforce the operating band
for ior
2. Last Resort Lending
Lender of Last Resort Function
1. To prevent banking panics
CDIC fund not big enough
Examples: Canadian Commercial Bank and Northland Bank
2. To prevent nonbank financial panics
Examples: 1987 ‘Black Monday’ stock market crash
Announcement Effect
1. Problem: False signals
Copyright © 2002 Pearson Education Canada Inc.
17- 26
Bank of Canada Advances to
Members of the CPA
With the failure of the
Canadian Commercial
and Northland banks in
1985, rumours of
trouble led to large
deposit withdrawals
from the Bank of
British Columbia,
Mercantile Bank, and
Continental Bank.
Copyright © 2002 Pearson Education Canada Inc.
By the time Mercantile was
acquired by the National
Bank of Canada, Bank of
British Columbia by the Hong
Kong Bank of Canada, and
Continental by Lloyds Bank
of Canada, the Bank of
Canada lent over $5 billion.
17- 27
Lending Policy
Advantages
1. Lender of Last Resort Role
Disadvantages
1. Confusion interpreting bank rate changes
2. Fluctuations in advances cause unintended fluctuations in money supply
3. Not fully controlled by Bank
Proposed Reforms
1. Abolish central bank lending (Milton Friedman)
s
A. Eliminates fluctuations in M
B. However, lose lender of last resort role
2. Tie bank rate to market rate
s
A. i – ib = constant, so fewer fluctuations of A and M
B. Easier administration
C. No false announcement signals
Copyright © 2002 Pearson Education Canada Inc.
17- 28
Should ib be Tied to
a Market Interest Rate?
For most of the last two decades, the Bank of Canada operated
under a floating bank rate regime. That is, ib was tied to a
specific market interest rate. For example, from March 1980 to
February 1996, ib was set each week at 25 basis points above the
average 3-month T-bill rate.
In February 1996 the Bank switched to a fixed bank rate regime,
with ib being the upper limit of the operating band for ior.
Moreover, in December 2000, the Bank introduced a system of
eight fixed dates throughout the year for announcing changes (if
any) to ib, keeping the option to act between the fixed dates in
extraordinary circumstances.
Figure 17-7 shows the spread between ib and ior since 1975.
Copyright © 2002 Pearson Education Canada Inc.
17- 29
Spread Between ib and ior
Copyright © 2002 Pearson Education Canada Inc.
17- 30
The U.S. Fed’s Discount Rate id
In contrast to the Bank of Canada, the U.S. Federal Reserve does
not tie the discount rate to a market rate of interest, although it
pursues a policy that is consistent with a floating bank rate
regime.
That is, the Fed does not let id move too far from market rates
because it does not want discount loans to get out of control.
Moreover, unlike the Bank, the Fed operates under a system of ten
fixed dates throughout the year for announcing changes (if any) to
id.
There is no correlation between the Bank of Canada’s eight preset announcement dates for ib changes with those of the Fed’s for
id changes.
Copyright © 2002 Pearson Education Canada Inc.
17- 31
Advantages of a Flexible ib Regime
Many economists support a floating bank rate regime. They argue
that by tying ib to a market interest rate (such as the 3-month Tbill rate):
• the Bank of Canada can continue to perform its role as lender of
last resort.
• most fluctuations between ib and market rates are eliminated. In
fact, i – ib = constant, so fewer fluctuations of A and M.
• there is easier administration of the discount window, there are no
false signals about the intentions of the central bank, and hence
any possible announcement effects disappear.
Copyright © 2002 Pearson Education Canada Inc.
17- 32
Advantages of a Fixed ib Regime
Other economists oppose a flexible ib because they think that
keeping ib fixed when market rates change would  fluctuations
in market rates. For example, keeping ib fixed when market rates
 would  A and M, possibly countering some of the  in market
interest rates.
The most important advantage, however, of a fixed ib regime is
that the Bank of Canada can signal its intentions about future
monetary policy. For example, if the Bank wants to slow the
expansion of the economy by  the target ior, it can amplify the
announcement by also  ib.
The problem is that ib changes can be subject to misinterpretation.
Copyright © 2002 Pearson Education Canada Inc.
17- 33
False Signals and Announcement
Effects
If, for example, ior  above the target ior, A will  . In such a
case, the Bank might have no intention of  ib but to keep A from
becoming excessive it may  ib to keep it more in line with market
rates.
When ib  the market may interpret this as a signal that the Bank
of Canada is moving to a more contractionary policy, even if this
is not the case. The announcement effect may be a hindrance
rather than a help.
Copyright © 2002 Pearson Education Canada Inc.
17- 34
Government Deposit Shifting
Prior to the introduction of the LVTS, the management of
settlement balances (cash setting) was the main mechanism
by which the Bank of Canada implemented monetary policy.
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.
In the LVTS environment, however, the Bank uses twicedaily auctions of government term deposits (the first at 9:15
a.m. and the second at 4:15 p.m.) to effect the shifting of
government funds and neutralize certain government flows.
Copyright © 2002 Pearson Education Canada Inc.
17- 35
… 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  in ior, the Bank
neutralizes the net government receipt by morning (9:15 a.m.) and
afternoon (4:00 p.m.) auctions of government term deposits, as
follows:
Bank of Canada
Assets
Direct Clearers
Assets
Settlement Balances +100
Copyright © 2002 Pearson Education Canada Inc.
Liabilities
Government Deposits - 100
Settlement Balances +100
Liabilities
Government Deposits +100
17- 36
… Neutralizing a Net Government
Disbursement
If there were a net government disbursement of $100 (i.e., the
government's payments to the public exceed its receipts from the public
by $100), then settlement balances would  by the same amount. To
prevent a  in ior, the Bank neutralizes the net government disbursement
by a transfer of $100 from the government's accounts at the LVTS
participants to the government's account at the Bank:
Bank of Canada
Assets
Direct Clearers
Assets
Settlement Balances -100
Copyright © 2002 Pearson Education Canada Inc.
Liabilities
Government Deposits + 100
Settlement Balances
-100
Liabilities
Government Deposits -100
17- 37
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 EFA.
If the Bank temporarily buys $100 of FX from the EFA, then:
Bank of Canada
Assets
Foreign exchange +100
Government of Canada
Assets
EFA
-100
Liabilities
Government Deposits + 100
Liabilities
Deposits at the Bank +100
Government deposits at the Bank  and now can be transferred
to banks to  settlement balances.
Copyright © 2002 Pearson Education Canada Inc.
17- 38
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 ior, 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%
From this announcement, LVTS participants know that the ib
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 ior, the midpoint of the operating band, shifts from
4.75% to 5%
If later in the day overnight funds are trading below the target
ior, the Bank enters into SRAs to enforce the new target for ior
Copyright © 2002 Pearson Education Canada Inc.
17- 39
An Example of Monetary Control
(continued)
Assuming that the Bank enters into SRAs in the amount of $100, the
T-accounts of the Bank and the direct clearers will be:
Bank of Canada
Assets
Liabilities
Settlement Balances
SRAs
Direct Clearers
Assets
Settlement Balances -100
SRAs
Copyright © 2002 Pearson Education Canada Inc.
-100
+100
Liabilities
+100
17- 40
An Example of Monetary Control
(continued)
Because settlement balances  the Bank neutralizes the effect
on settlement balances of its issue of SRAs, by auctioning off
$100 of government deposits :
Bank of Canada
Assets
Direct Clearers
Assets
Settlement Balances +100
Copyright © 2002 Pearson Education Canada Inc.
Liabilities
Settlement Balances
+100
Government Deposits -100
Liabilities
Government Deposits +100
17- 41
An Example of Monetary Control
(continued)
The end-of-day effect on the balance sheets of the Bank and
the direct clearers is as follows:
Bank of Canada
Assets
Direct Clearers
Assets
SRAs
+100
Liabilities
SRAs
+100
Government Deposits -100
Liabilities
Government Deposits +100
The Bank’s monetary tightening has been effected through the
management of settlement balances, during the course of the
day, with no change in the aggregate settlement balances
Copyright © 2002 Pearson Education Canada Inc.
17- 42