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Chapter 17 Tools of Monetary Policy © 2005 Pearson Education Canada Inc. Chapter 17 Tools of Monetary Policy © 2005 Pearson Education Canada Inc.

Overview So far we derived a multiplicative relation between M and MB M = 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. © 2005 Pearson Education Canada Inc. 2

The Role of Money Before we go on, we have to clear up a 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. © 2005 Pearson Education Canada Inc. 3

The Large Value Transfer System, LVTS • • • The LVTS (introduced on February 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 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 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 © 2005 Pearson Education Canada Inc. 4

LVTS Participants As of November 2002, in addition to the Bank of Canada, there LVTS Participants As of November 2002, 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, and the Laurentian Bank of Canada. © 2005 Pearson Education Canada Inc. 5

Systemic Risk The LVTS has been put in place to eliminate systemic risk. In 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 © 2005 Pearson Education Canada Inc. 6

Real-Time Settlement Systems in Other Countries The LVTS has been put in place in 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 Belgiumand U. K. France, Hong Kong, and NL © 2005 Pearson Education Canada Inc. Year introduced 1918 1986 1987 1988 1989 1996 1997 7

Non-LVTS Transactions • • • These are non-LVTS (paper-based) payment items, such as cheques 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 © 2005 Pearson Education Canada Inc. 8

Direct and Indirect Clearers Direct Clearers: • The subset of LVTS participants who participate 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 © 2005 Pearson Education Canada Inc. 9

The Operating Band of 50 Basis Points for the Overnight Interest Rate The upper 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 © 2005 Pearson Education Canada Inc. 10

The Bank’s Standing Liquidity Facilities At the end of each day, each LVTS participant 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. © 2005 Pearson Education Canada Inc. 11

Pre-settlement Trading Participants can reduce the costs of either positive or negative positions by Pre-settlement Trading Participants can reduce the costs of either positive or negative positions by trading with each other in the LVTS pre-settlement period at the end of the day (6: 006: 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. 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. © 2005 Pearson Education Canada Inc. 12

The Market Timetable © 2005 Pearson Education Canada Inc. 13 The Market Timetable © 2005 Pearson Education Canada Inc. 13

The Bank’s Implementation of the Operating Band for ior If ior towards the upper 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 © 2005 Pearson Education Canada Inc. 14

Supply and Demand for Settlement Balances and Overnight Interest Rate, ior The equilibrium ior Supply and Demand for Settlement Balances and Overnight Interest Rate, ior 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. © 2005 Pearson Education Canada Inc. 15

The Bank’s Current Approach to Monetary Policy In February 1991, the Bank’s governor and 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%. © 2005 Pearson Education Canada Inc. 16

How the Bank Keeps From Falling Below the Target Range The Bank expects the 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 © 2005 Pearson Education Canada Inc. The in i and E lead to an in M, AD, and P, thereby preventing from falling below the target range. 17

How the Bank Keeps From Moving Above the Target Range The Bank expects the How the Bank Keeps From Moving Above the Target Range The Bank expects the economy to be exceeding its capacity in the future and wishes to slow it down. 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 in order to prevent inflationary pressures from building. © 2005 Pearson Education Canada Inc. 18

The Bank’s Influence on Long-Term Interest Rates By changing the operating band for ior 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 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. © 2005 Pearson Education Canada Inc. 19

Open Market Operations Two Types 1. Dynamic: Meant to change MB 2. Defensive: Meant 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. 2. 3. 4. Bank has complete control Flexible and precise Easily reversed Implemented quickly © 2005 Pearson Education Canada Inc. 20

SPRAs and SRAs Over the years, the Bank introduced additional tools in its conduct SPRAs and SRAs Over the years, the Bank introduced additional tools in its conduct of monetary policy. 1. 2. 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. SPRAs and SRAs, are conducted with primary dealers (formerly known as jobbers) --- the Big Six and the major investment dealers. © 2005 Pearson Education Canada Inc. 21

The Bank’s Use of SPRAs to Reinforce the Target ior If overnight funds are 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 © 2005 Pearson Education Canada Inc. 22

The Bank’s Use of SRAs to Reinforce the Target ior If overnight funds are 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 © 2005 Pearson Education Canada Inc. 23

Bank of Canada Lending (Advances) Two Types 1. Standing Liquidity Facility, to reinforce the 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 © 2005 Pearson Education Canada Inc. 24

Bank of Canada Advances to Members of the CPA © 2005 Pearson Education Canada Bank of Canada Advances to Members of the CPA © 2005 Pearson Education Canada Inc. 25

Lending Policy Advantages 1. Lender of Last Resort Role Disadvantages 1. Confusion interpreting bank 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 © 2005 Pearson Education Canada Inc. 26

Government Deposit Shifting Prior to the introduction of the LVTS, the management of settlement 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 twice-daily 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. © 2005 Pearson Education Canada Inc. 27

Neutralizing a Net Government Receipt Consider a net government receipt of $100 (i. e. 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 © 2005 Pearson Education Canada Inc. Liabilities Government Deposits - 100 Settlement Balances +100 Liabilities Government Deposits +100 28

Neutralizing a Net Government Disbursement If there were a net government disbursement of $100 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 © 2005 Pearson Education Canada Inc. Liabilities Government Deposits + 100 Settlement Balances -100 Liabilities Government Deposits -100 29

Swaps With the Exchange Fund Account (EFA) The Bank usually brings onto its balance 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. © 2005 Pearson Education Canada Inc. 30

An Example of Monetary Control • • Suppose that the operating band is 4. 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 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 © 2005 Pearson Education Canada Inc. 31

(Continued) Assuming that the Bank enters into SRAs in the amount of $100, the (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 -100 SRAs +100 Direct Clearers Assets Settlement Balances -100 SRAs © 2005 Pearson Education Canada Inc. Liabilities +100 32

(Continued) Because settlement balances the Bank neutralizes the effect on settlement balances of its (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 © 2005 Pearson Education Canada Inc. Liabilities Settlement Balances +100 Government Deposits -100 Liabilities Government Deposits +100 33

(Continued) The end-of-day effect on the balance sheets of the Bank and the direct (Continued) The end-of-day effect on the balance sheets of the Bank and the direct clearers is as follows: Bank of Canada Assets Liabilities SRAs +100 Government Deposits -100 Direct Clearers Assets SRAs +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 © 2005 Pearson Education Canada Inc. 34