CHAPTER 17 Tools of Monetary Policy 443 term interest rates Why? Because the turmoil in the financial markets has increased risk premiums, thereby keeping long-term nominal interest rates high Moreover, with collapsing asset prices (stock and real estate prices), there has been an increase in deflationary expectations, which led to a rise in real interest rates This has the potential to make monetary policy highly contractionary, despite falling short-term nominal interest rates Now that we understand how the overnight rate is determined and the Bank of Canada s approach to monetary policy, we can examine how changes in the three tools of monetary policy open market operations, settlement balances management, and Bank of Canada lending affect the market for reserves and the equilibrium overnight interest rate OP EN MA RKET OP E RAT I O NS Open market operations are an important monetary policy tool for many central banks around the world, because they are the primary determinants of changes in interest rates and the monetary base, the main source of fluctuations in the money supply Open market purchases expand bank reserves and the monetary base, thereby lowering short-term interest rates and raising the money supply Open market sales shrink bank reserves and the monetary base, raising short-term interest rates and lowering the money supply The Bank of Canada, however, stopped conducting open market operations in Government of Canada treasury bills and bonds in 1994, and its most common operations since then have been repurchase transactions with primary dealers (formerly known as jobbers) the Big Six and the major investment dealers In particular, the Bank uses repos, which in Canada are known as special Purchase and Resale Agreements (special PRAs or SPRAs), as a tool to reduce undesired upward pressure on the overnight interest rate, and reverse repos, known in Canada as Sale and Repurchase Agreements (SRAs), as a tool to reduce undesired downward pressure on the overnight rate Let s see how the Bank of Canada uses special PRAs and SRAs in order to reinforce the target for the overnight interest rate during the course of a day Special PRAs Assume that the operating band for the overnight interest rate is 3.5% to 4% and that the Bank of Canada is targeting the overnight rate at the midpoint of the band, at 3.75% If overnight funds are traded at a rate higher than the target rate of 3.75%, then the Bank of Canada enters into special PRAs, typically at 11:45 at a price that works out to a 3.75% interest rate, the midpoint of the operating band That is, the Bank purchases Government of Canada treasury bills or bonds, with an agreement that the seller will repurchase them one business day later (see Figure 17-6 regarding the mechanics of a special PRA) Since the securities are placed with the Canadian Depository for Securities (CDS), Canada s central securities depository owned and operated by the financial community, the title of the securities changes hands by electronic instruction The balance sheets of the Bank of Canada and the primary dealers look like this: Bank of Canada Assets Government securities Primary Dealers Liabilities *$100 Settlement balances Assets *$100 Settlement balances Liabilities *$100 SPRAs *$100