Transcript Chpt #17

Chapter 17
Tools of Monetary
Policy
17.1
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Overview
• So far we derived a multiplicative relation
between the money supply and the
monetary base
• 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
17.2
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Overview
(Cont’d)
• 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.
17.3
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The Large Value Transfer
System (LVTS)
•
The LVTS (introduced in 1999) is an electronic,
real-time net settlement network, designed to
provide immediate finality and settlement to timecritical transactions
•
LVTS participants know in real time their largevalue, 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
17.4
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• 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
17.5
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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
17.6
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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
17.7
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• 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
17.8
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Direct Clearers
• The subset of LVTS participants who
participate directly in the ACSS and are
known as direct clearers
17.9
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The Operating Band for the
Overnight Interest Rate
• 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.
17.10
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• Such changes influence other short-term
interest rates and the exchange rate
17.11
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The Operating Band for the
Overnight Interest Rate (Cont’d)
• 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
17.12
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The Operating Band for the
Overnight Interest Rate (Cont’d)
17.13
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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 facilities) to provide or absorb liquidity
with an overnight duration to participants facing
unforeseen liquidity shocks.
17.14
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The Bank’s Standing
Liquidity Facilities (Cont’d)
• 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.
17.15
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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
17.16
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The Channel/Corridor System
for the Overnight Rate
• 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
17.17
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How Monetary Policy Affects
the Economy
17.18
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How Monetary Policy Affects the
Economy (Cont’d)
• 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
17.19
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How Monetary Policy Affects the
Economy (Cont’d)
17.20
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How Monetary Policy Affects the
Economy (Cont’d)
17.21
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Open Market Operations
• 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
17.22
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• Open market sales reduce bank reserves
and the monetary base, increasing interest
rates and reducing the money supply
17.23
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Open Market Operations
(Cont’d)
• 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
17.24
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SPRAs and SRAs
• 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)
17.25
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• 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.
• See Table 9.1 of textbook which shows
balance sheets of the chartered banks with
the liabilities called ‘obligations related to
sales sold under repos’
17.26
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SPRAs and SRAs
•
(Cont’d)
SPRAs and SRAs are conducted with primary
dealers (formerly known as jobbers) --- the Big
Six and the major investment dealers.
Special Purchase and Resale Agreements
(SPRAs) are a tool to reduce undesired upward
pressure on the overnight rate
•
17.27
Sale and Repurchase Agreements (SRAs) are a
tool to reduce undesired downward pressure on
the overnight rate
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The Bank’s Use of SPRAs to
Reinforce the Target ior
1. 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.
2. Hence, SPRAs relieve undesired upward
pressure on ior
17.28
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The Bank’s Use of SRAs to
Reinforce the Target ior
1. 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.
2. Hence, SRAs relieve undesired downward
pressure on ior
17.29
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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
17.30
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Bank of Canada (Advances)
•
Standing Liquidity Facility, to reinforce the
operating band for ior
•
Last Resort Lending
Lender of Last Resort Function
•
To prevent financial panics
•
CDIC fund not big enough
17.31
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Lending Policy
Advantages
• 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
17.32
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Government Deposit Shifting
•
17.33
Prior to the introduction of the LVTS,
management of settlement balances (cash
setting) was the main mechanism by
which the Bank of Canada implemented
monetary policy.
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• 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.
17.34
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Swaps With the Exchange Fund
Account (EFA)
•
17.35
The Bank usually brings onto its
balance sheet EFA assets to back its
liabilities. It does so by arranging a
swap with the Exchange Fund Account
(EFA). If the Bank temporarily buys
$100 of FX from the EFA – see next
slide
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Swaps With the Exchange Fund
Account (EFA) (Cont’d)
Bank of Canada
Assets
Foreign exchange +100
Liabilities
Government Deposits + 100
Government of Canada
Assets
Liabilities
EFA
-100
Deposits at the Bank +100
•
17.36
Government deposits at the Bank  and now can
be transferred to banks to  settlement balances.
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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%
17.37
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An Example of Monetary
Control (Cont’d)
• 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%
17.38
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• 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
17.39
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Monetary Policy of the
Federal Reserve in U.S.
the institutional arrangements and the mechanism are
quite than Canada
17.40
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Monetary Policy of the
Federal Reserve in U.S
• Open market operations
– Affect the quantity of reserves and the monetary base
• Discount lending
– Affect the monetary base
• Changes in reserve requirements
– Affect the money multiplier
• Federal funds rate (iff) - the interest rate on
overnight loans of reserves from one bank to
another
– Primary indicator of the stance of monetary policy
17.41
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The Market for Reserves
• Two components: non-borrowed and
borrowed reserves
• Cost of borrowing from the Fed is the
discount rate (id)
• Borrowing from the Fed is a substitute for
borrowing from other banks
• If iff < id, then banks will not borrow from the
Fed and borrowed reserves are zero
17.42
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• The supply curve will be vertical (assumes a closed
economy)
• As iff rises above id, banks will borrow more
and more at id, and re-lend at iff
• The supply curve is horizontal (perfectly
elastic) at id
17.43
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The Market for Reserves
17.44
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Open Market Operations
• An open market purchase causes the federal
funds rate to fall; an open market sale
causes the federal funds rate to rise
shifting the supply curve
• If the intersection of supply and demand
occurs on the vertical section of the supply
curve, a change in the discount rate will have
no effect on the federal funds rate
17.45
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Open Market Operations
(Cont’d)
17.46
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Discount Lending
17.47
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Reserve Requirements
17.48
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Monetary Policy Tools
of the European Central Bank
• Read on your own
17.49
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