Chapter 17

1. Chapter 17 Money, Banking, and Financial Markets: The Central Bank Balance Sheet and the Tools of Monetary Policy Tim Berry, Humber College ©2010 McGraw-Hill Ryerson Ltd.

2. The Central Bank Balance Sheet and Monetary Policy: The Big Questions • How does the central bank interact with the financial system? • What is the structure of the central bank’s balance sheet? • How is the central bank balance sheet connected to monetary policy? 17-2 ©2010 McGraw-Hill Ryerson Ltd.

3. The Central Bank Balance Sheet and Monetary Policy: Roadmap • The Central Bank’s Balance Sheet • Changing the Size and Composition of the Balance Sheet • The Operation of Monetary Policy • Linking Tools to Objectives: Making Choices 17-3 ©2010 McGraw-Hill Ryerson Ltd.

4. The Central Bank’s Balance Sheet 17-4 ©2010 McGraw-Hill Ryerson Ltd.

5. The Central Bank’s Balance Sheet:Assets • Securities • B.O.C. usually holds only Gov. of Canada securities • controlled through purchases and sales known as “open market operations” • Foreign Exchange Reserves • bonds issued by foreign governments • Loans • Discount loans 17-5 ©2010 McGraw-Hill Ryerson Ltd.

6. Comparing the Fed with the Bank of Canada: • Both hold majority of their assets in form of securities • Both are similar on the liability side with most being notes outstanding • People’s Bank of China: • Balance sheet has very different structure from B.O.C. and Fed • Very high foreign exchange reserves • High level of loans in form of bonds 17-7 ©2010 McGraw-Hill Ryerson Ltd.

7. The Central Bank’s Balance Sheet:Liabilities • Currency • Government Accounts • Reserves • Deposits of financial institutions 17-6 ©2010 McGraw-Hill Ryerson Ltd.

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9. Importance of Disclosure • Central banks have to publish their balance sheets. • Most central banks publish it weekly. • Misrepresentation is a sign of impending disaster. 17-9 ©2010 McGraw-Hill Ryerson Ltd.

10. Monetary Base • Equals currency plus reserves • Also known as high-powered money • Money and credit in the economy is basedon this. • We’ll see how in a moment. 17-10 ©2010 McGraw-Hill Ryerson Ltd.

11. The Size of the Central Bank’s Balance Sheet • The central bank controls the size of its balance sheet. • When it buys a security, it can create reserves to pay for them. 17-11 ©2010 McGraw-Hill Ryerson Ltd.

12. The Central Bank’s Balance Sheet:Changing the Size & Composition • Open Market Operations Buying or selling a security initiated by the central bank • Loans to a Financial Institution B.O.C. doesn’t force banks to borrow money – they ask for loans • Shifting Govt. DepositsMoving Govt. of Canada balances from Govt. acct at B.O.C. to Govt. accts. In the financial system • Cash Withdrawal Initiated by the nonbank public 17-12 ©2010 McGraw-Hill Ryerson Ltd.

13. Why hasn’t cash disappeared? • Convenience • Avoid paying taxes • Anonymity • If the only people using cash were criminals we should get rid of it 17-13 ©2010 McGraw-Hill Ryerson Ltd.

14. The Central Bank’s Balance Sheet: Open Market Operations 17-14 ©2010 McGraw-Hill Ryerson Ltd.

15. The Central Bank’s Balance Sheet 17-15 ©2010 McGraw-Hill Ryerson Ltd.

16. The Central Bank’s Balance Sheet 17-16 ©2010 McGraw-Hill Ryerson Ltd.

17. The Central Bank’s Balance Sheet: Cash Deposit 17-17 ©2010 McGraw-Hill Ryerson Ltd.

18. The Central Bank’s Balance Sheet:Summary 17-18 ©2010 McGraw-Hill Ryerson Ltd.

19. Immediately following the September 11 attacks one large bank could not make payments, it could only receive them. • Other banks started to have problems obtaining reserves to make payments • To make sure the financial system continued to function, the Fed increased reserves by nearly $150 billion for a few days 17-19 ©2010 McGraw-Hill Ryerson Ltd.

20. Operation of Monetary Policy The Bank of Canada’s Operational Framework: • B.O.C. sets overnight target interest rate • This is the rate at which financial institutions lend to each other – very short-term • The Bank rate is rate at which the B.O.C. lends to eligible financial institutions 17-20 ©2010 McGraw-Hill Ryerson Ltd.

21. Operation of Monetary Policy 17-21 ©2010 McGraw-Hill Ryerson Ltd.

22. Operation of Monetary Policy The Federal Reserve’s Operational Framework: • Main tool is the target federal funds rate • Fed funds rate is the equivalent of the B.O.C. overnight rate – except they are uncollateralized • Primary discount rate is rate at which Fed lends to financial institutions approved by Fed • Similar to B.O.C. Bank rate 17-22 ©2010 McGraw-Hill Ryerson Ltd.

23. Operation of Monetary Policy The Federal Reserve’s Operational Framework: 17-23 ©2010 McGraw-Hill Ryerson Ltd.

24. Operation of Monetary Policy The European Central Bank’s Operational Framework: • ECB’s main tool is the overnight interbank rate • This is the rate at which ECB lends to commercial banks • ECB provides reserves to European banking system through refinancing operations • ECB works through national central banks by providing reserves to banks in exchange for securities • System designed to give ECB control over short- term interest rates in the euro region 17-24 ©2010 McGraw-Hill Ryerson Ltd.

25. Operation of Monetary Policy The European Central Bank’s Operational Framework: 17-25 ©2010 McGraw-Hill Ryerson Ltd.

26. Linking Tools to Objectives: Making Choices Desirable Features of a Policy Instrument: • A good monetary policy instrument has three features: • 1. It is easily observable by everyone. • 2. It is controllable and quickly changed. • 3. It is tightly linked to the policymakers’ objectives. 17-26 ©2010 McGraw-Hill Ryerson Ltd.

27. Linking Tools to Objectives: Making Choices Operating Instruments and Intermediate Targets: • Operating instruments refer to actual tools of policy. • These are instruments that the central bank controls directly. • Every central bank can control the size of its balance sheet. 17-27 ©2010 McGraw-Hill Ryerson Ltd.

28. Linking Tools to Objectives: Making Choices Operating Instruments and Intermediate Targets: • Intermediate targets to refer to instruments that are not directly under central bank control but lie instead somewhere between their policymaking tools and their objectives • The monetary aggregates are a prime example of intermediate targets 17-28 ©2010 McGraw-Hill Ryerson Ltd.

29. Linking Tools to Objectives: Making Choices Operating Instruments and Intermediate Targets: 17-29 ©2010 McGraw-Hill Ryerson Ltd.

30. Chapter Summary • The central bank uses its balance sheet to • control the quantity of money and credit in the economy. • a. The central bank holds assets and liabilities to • meet its responsibilities as the government’s • bank and the bankers’ bank. • b. Central bank assets can include securities, • foreign exchange reserves, and loans. 17-30 ©2010 McGraw-Hill Ryerson Ltd.

31. Chapter Summary • cont’d • c. Central bank liabilities include currency, the • government’s account, and deposits of • financial institutions. • d. Reserves equal commercial bank account • balances at the central bank plus vault cash. • e. The monetary base, also called high-powered • money, is the sum of currency and reserves, • the two primary liabilities of a central bank. 17-31 ©2010 McGraw-Hill Ryerson Ltd.

32. Chapter Summary 2. The central bank controls the size of its balance sheet. a. The central bank can increase the size of its balance sheet, raising reserve liabilities and expanding the monetary base, through: i. Open market purchases of domestic securities. ii. The purchase of foreign exchange reserves (in the form of bonds issued by a foreign government). iii. The extension of a loan to a commercial bank. 17-32 ©2010 McGraw-Hill Ryerson Ltd.

33. Chapter Summary 2. cont’d b. The central bank can decrease the size of its balance sheet, lowering reserve liabilities and reducing the monetary base, through the sale of domestic or foreign securities. c. The public’s cash withdrawals from banks shift the central bank’s liabilities from reserves to currency and shrink the size of the banking system balance sheet. 17-33 ©2010 McGraw-Hill Ryerson Ltd.

34. Chapter Summary 3. The Bank of Canada sets the operating range, which includes: a. The target for the overnight rate. b. The Bank rate, 25 bps above the overnight rate. c. The interest rate on deposits of financial institutions at the Bank of Canada, 25 bps below the target for the overnight rate. 17-34 ©2010 McGraw-Hill Ryerson Ltd.

35. Chapter Summary 4. The Bank of Canada ensures that the overnight rate stays close to its target: a. Because the direct clearers in the Canadian Payments Association settle their balances on the books of the Bank of Canada. b. By using open market operations (SPRAs) and movements of government deposits between the Bank of Canada and the financial institutions. 17-35 ©2010 McGraw-Hill Ryerson Ltd.

36. Chapter Summary 5. Other central banks operate in a similar but not identical fashion: a. The target federal funds rate is the primary instrument of monetary policy for the Federal Reserve, which uses open market operations to control the federal funds rate. 17-36 ©2010 McGraw-Hill Ryerson Ltd.

37. Chapter Summary 5. cont’d b. The European Central Bank’s primary objective is price stability and it targets the refinancing rate (the minimum bid rate on the main refinancing operations) to implement monetary policy. c. Unlike the Bank of Canada, both the Fed and the ECB have required reserves but these are not used very often for monetary policy implementation. 17-37 ©2010 McGraw-Hill Ryerson Ltd.

38. Chapter Summary 6. Central banks have routine lending facilities (Standing Liquidity Facilities in Canada) and emergency lending facilities (Emergency Lending Assistance in Canada). 17-38 ©2010 McGraw-Hill Ryerson Ltd.

39. Chapter Summary • 7. Monetary policymakers use several tools to • meet their objectives. • The best tools are observable, controllable, • and tightly linked to objectives. • b. Short-term interest rates are the best tools for • monetary policymaking. • c. Modern central banks do not use intermediate • targets such as money growth. 17-39 ©2010 McGraw-Hill Ryerson Ltd.

40. Chapter 17 Money, Banking, and Financial Markets: The Central Bank Balance Sheet and the Tools of Monetary Policy End of Chapter Tim Berry, Humber College ©2010 McGraw-Hill Ryerson Ltd.