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Chapter 17

EC223 Chapter Notes - Chapter 17: Excess Reserves, Pras, Quantitative Easing

Course Code
Angela Trimarchi

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EC223 Chapter 17 Tools of Monetary Policy Week 10
Overnight rate the interest rate on overnight loans of reserves from one bank to another, as the
primary instrument of monetary policy
The Framework for the Implementation of Monetary Policy
-The tools used by the Bank of Canada to implement monetary policy are closely linked to the
institutional arrangements regarding the clearing and settlement systems in the Canadian economy
The Large Value Transfer System (LVTS)
-An electronic, real-time net settlement network, designed to provide immediate finality and settlement
to time-critical transactions
-In addition to the Bank of Canada, there are 14 LVTS participants
-The LVTS has been put into place in order to eliminate systematic risk the risk to the entire payments
system due to the inability of one financial institution to fulfill its payment obligations in a timely fashion
-Each LVTS payment is subject to real time risk-control tests to confirm that sufficient collateral is
available, and is final and irrevocable in real time
-Participants know in real time their large-value, wholesale transactions
-The LVTS is used to settle over 20 000 payments daily, with a value of over $185 billion
-The LVTS uses multilateral netting in which only the net credit or debit position of each participant vis-
à-vis all other participants is calculated for settlement, thereby reducing the need for a large amount of
settlement balanced
Non-LVTS (ACSS) Transactions
-Paper based payment items (paper cheques, travellers’ cheques, gift certificates, money orders) and
electronic payments items
-Aggregates interbank payments and calculates the net amounts to be transferred from and to each
participant’s settlement account with the Bank of Canada
-Direct clearers members of the Canadian Payments Association who participate directly in the
Automated Clearing Settlement System (ACSS)and maintain a settlement account at the Bank of Canada
The Bank of Canada’s Policy Rate
-Overnight interest rate/reference rate the interest rate at which participants borrow and lend
overnight funds to each other in the money market
-Policy rate the target for the Bank of Canada’s overnight interest rate
The Operating Bank for the Overnight Interest Rate
-Operating band the Bank’s operational objective is to keep the overnight rate within an operating
band of twenty-five basis points
The Bank of Canada’s Standing Facilities
-The Bank of Canada stands ready to lend to or borrow from a participant to bring their settlement
balanced to zero at the end of the banking day
The Bank of Canada’s Implementation of the Operating Bank for the Overnight Interest Rate
-If the overnight rate increases towards 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 declines towards the lower limit of the operating band, then the Bank will accept
EC223 Chapter 17 Tools of Monetary Policy Week 10
deposits from LVTS participants at the bank rate less 50 basis points, to put a floor on the overnight rate
The Market for Settlement Balances and the Channel/Corridor System for Setting the Overnight
Interest Rate
-The market for settlement balances is where the overnight interest rate is determined
-The market to analyze the markets for reserves proceeds in a similar fashion to the analysis of the bond
market and describes determination of the overnight interest rate in a channel/corridor system of
interest-rate control
The Bank of Canada’s Approach to Monetary Policy
-The goal of the Bank of Canada’s current monetary policy is to keep the inflation rate within a target
range of 1% to 3% with the midpoint of the inflation target range, 2%, being the most desirable outcome
How Monetary Policy Affects the Economy
-The level of short-term interest rates and the exchange rate of the Canadian dollar determine the
monetary conditions in which the economy operates
-By changing the target and operating band for the overnight rate, the Bank of Canada sends a signal
regarding the direction that it would like interest rates and the money supply to take
Nominal Interest Rates and Monetary Policy
-The Bank of Canada uses the nominal overnight interest rate as its operating instrument
-Changes in the short-term nominal interest rates affect short- and long-term real interest rates
Open Market Operations
-An important monetary policy tool for many central banks around the world
-The primary determinants of changes in interest rates and the monetary base, the main source of
fluctuations in the money supply
-Primary dealers Government securities dealers, operating out of private firms or commercial banks,
with whom the Bank of Canada’s open market desk trades
-Special Purchase and Resale Agreements (special PRAs or SPRAS)/repo The Bank of Canada’s purchase
of government securities from primary dealers with an agreement to resell them one business day later
-Sale and Repurchase Agreements (SRAs)/Reverse repo The Bank of Canada’s sale of government
securities to primary dealers with an agreement to repurchase them one business day later
Special PRAs
-Repos, also known as special Purchase and Resale Agreements, relieve undesired upward pressure on
the overnight interest rate
-Reverse repos, also known as Sale and Repurchase Agreements (SRAs), alleviate undesired downward
pressure on the overnight financing rate
Advantages of SPRAs and SRAs
-They occur at the initiative of the Bank of Canada, which has complete control over their volume, and
are easily reversed
EC223 Chapter 17 Tools of Monetary Policy Week 10
Settlement Balances Management
-The Bank of Canada also targets the level of settlement balances in the system
-Recently, the Bank made several adjustments to the target level of settlement balances
-The Bank of Canada usually neutralizes the impact on settlement balances of any open-market-buyback
The Target Level of Settlement Balances
-The Bank of Canada can also adjust the target level of settlement balances if warranted by conditions in
the overnight market
-The Bank retains the right to adjust the targeted level of settlement balances higher or lower than the
typical setting, depending on pressures on the overnight rate
Monetary Policy at the Effective Lower Bound for the Overnight Rate
-As the policy rate has reached the effective lower bound, the Bank of Canada has lost its usual ability to
signal policy changes via changes in the policy rate
-The Bank of Canada has also lost its ability to lower long-term interest rates by lowering short-term
interest rates
Conditional Statements
-Because the Bank of Canada has lost its ability to influence long-term interest rates using conventional
monetary policy tools, recently the Bank started making conditional statements about the future path of
its policy rate in order to influence long-term interest rates
Quantitative Easing
-Refers to the purchase of financial assets by the central bank through the creation of excess reserves
for banks
Credit Easing
-Refers to the purchase of private sector assets by the central bank in critical markets that are
considered important for the effective functioning of the economy
Bank of Canada Lending
-The facility at which banks can borrow reserves from the Bank of Canada is called the standing lending
Operation of the Standing Lending Facility
-The Bank of Canada offers a lending facility, sanding ready to lend overnight settlement balances to
LVTS participants with negative clearing balances at the end of the business day
Lender of Last Resort
-The Bank of Canada’s lending is also important in preventing financial panics
-Avoiding financial panics by performing the role of lender of last resort is an extremely important
requirement of successful monetary policymaking
-The Bank of Canada advanced considerable funds in the recent past to financial institutions facing
liquidity crises