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

©2010 McGraw-Hill Ryerson Ltd. The Central Bank Balance Sheet and Monetary Policy: The Big Questions 1.How does the central bank interact with the financial system? 2.What is the structure of the central bank’s balance sheet? 3.How is the central bank balance sheet connected to monetary policy? 17-2

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

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

17-8 ©2010 McGraw-Hill Ryerson Ltd.

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. Monetary Base Equals currency plus reserves Also known as high-powered money Money and credit in the economy is based on this. We’ll see how in a moment

©2010 McGraw-Hill Ryerson Ltd. 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

The Central Bank’s Balance Sheet: Changing the Size & Composition 1.Open Market Operations Buying or selling a security initiated by the central bank 2.Loans to a Financial Institution B.O.C. doesn’t force banks to borrow money – they ask for loans 3.Shifting Govt. Deposits Moving Govt. of Canada balances from Govt. acct at B.O.C. to Govt. accts. In the financial system 4.Cash Withdrawal Initiated by the nonbank public ©2010 McGraw-Hill Ryerson Ltd

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

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

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

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

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

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. 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

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

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 ©2010 McGraw-Hill Ryerson Ltd

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

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

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

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

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. ©2010 McGraw-Hill Ryerson Ltd

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 ©2010 McGraw-Hill Ryerson Ltd

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

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