The economics of money, banking, and financial institutions 2nd ch17

Chapter 17 Tools of Monetary Policy © 2005 Pearson Education Canada Inc 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 whatever necessary to keep ior on target © 2005 Pearson Education 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 © 2005 Pearson Education 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 timecritical 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 © 2005 Pearson Education 17-4 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 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 © 2005 Pearson Education 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 Year introduced U.S (Fedwire) 1918 Sweden 1986 Germany and Switzerland 1987 Japan 1988 Italy 1989 Belgiumand U.K 1996 France, Hong Kong, and NL 1997 â 2005 Pearson Education 17-7 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 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 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 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 © 2005 Pearson Education 17-10 Open Market Operations Two Types Dynamic: Meant to change MB Defensive: Meant to offset other factors affecting MB Advantages of Open Market Operations Bank has complete control Flexible and precise Easily reversed Implemented quickly © 2005 Pearson Education 17-20 SPRAs and SRAs Over the years, the Bank introduced additional tools in its conduct of monetary policy 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 17-21 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 Liabilities SPRAs +100 Settlement Balances +100 Direct Clearers Assets Liabilities Settlement Balances +100 SPRAs +100 Hence, SPRAs relieve undesired upward pressure on ior © 2005 Pearson Education 17-22 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 Liabilities Settlement Balances - 100 SRAs +100 Direct Clearers Assets Liabilities Settlement Balances -100 SRAs +100 Hence, SRAs alleviate undesired downward pressure on ior © 2005 Pearson Education 17-23 Bank of Canada Lending (Advances) Two Types Standing Liquidity Facility, to reinforce the operating band for ior Last Resort Lending Lender of Last Resort Function To prevent banking panics CDIC fund not big enough Examples: Canadian Commercial Bank and Northland Bank To prevent nonbank financial panics Examples: 1987 ‘Black Monday’ stock market crash Announcement Effect Problem: False signals © 2005 Pearson Education 17-24 Bank of Canada Advances to Members of the CPA © 2005 Pearson Education 17-25 Lending Policy Advantages Lender of Last Resort Role Disadvantages Confusion interpreting bank rate changes Fluctuations in advances cause unintended fluctuations in money supply Not fully controlled by Bank © 2005 Pearson Education 17-26 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 17-27 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 Liabilities Government Deposits - 100 Settlement Balances +100 Direct Clearers Assets Liabilities Settlement Balances +100 © 2005 Pearson Education Government Deposits +100 17-28 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 Liabilities Government Deposits + 100 Settlement Balances -100 Direct Clearers Assets Liabilities Settlement Balances -100 © 2005 Pearson Education Government Deposits -100 17-29 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 17-30 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 © 2005 Pearson Education 17-31 (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 +100 -100 Direct Clearers Assets Liabilities Settlement Balances -100 SRAs +100 © 2005 Pearson Education 17-32 (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 Liabilities Settlement Balances +100 Government Deposits -100 Liabilities Government Deposits +100 17-33 (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 17-34 ... 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... 1998, and again in May 2001, to apply until the end of 2006 The goal of the Bank’s current policy is to keep π at the midpoint of the π target range, 2% © 2005 Pearson Education 17-16 How the Bank... 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