CSC1Q-Chapter 5

Operating band

- upper limit of the operating band - target range - lower limit of the operating band

If the Bank of Canada is concerned that interest rates are too high, what policy action can they take?

A redeposit is a transfer of funds from the Bank to the chartered banks. This increases deposits and reserves and the availability of funds in the banking system. Adding money to the system places downward pressure on interest and gives banks an incentive to increase loans to consumers and businesses.

fiscal agent

As fiscal agent to the Government, the Bank has a variety of functions. The Bank administers the Government's deposit accounts and funds. This includes: • Deposit accounts with the Bank of Canada and the chartered banks in which Government cash is held; and • The Exchange Fund Account, which holds the Government's foreign exchange reserves.

What is a significant negative implication for a country with a large national debt?

C. Fiscal policy options are restricted.

Press release

Changes in the overnight band (and therefore, the Bank Rate) are now accompanied by a press release explaining the Bank's actions. The Bank's intention is to make such changes as transparent (or clear) as possible to avoid confusion in financial markets.

The Federal Budget

Early each year, usually in February, the federal Minister of Finance presents to the House of Commons the federal budget for the upcoming fiscal year, which runs from April 1 to March 31. The budget contains projections for the coming year, and usually for at least one subsequent year, for spending, revenue, the amount of the projected surplus or deficit, and debt. An important part of the budget is the economic assumptions that underlie projections for tax revenue, debt service costs and other parts of the budget. The government's budget balance is equal to its revenues less its total spending. • If the revenue collected during the year exceeds spending for the year, the government has a budget surplus. • If total spending for the year is higher than the revenue collected, the government has a budget deficit for the year. • Accordingly, if the revenue collected for the year equals total spending, the government has a balanced budget. When the government runs a budget deficit, it must borrow to make up the difference by selling government bonds and Treasury bills into the market. • The accumulation of total government borrowing over time is referred to as the government debt or the national debt. It is the sum of past deficits minus the sum of past surpluses.

Other areas of spending

Federal and provincial governments oversee important areas of spending that do not appear on their respective budgets. These include the Canada and Quebec Pension Plans, Workplace Safety and Insurance Board, the Export Development Corp., and a wide range of other crown corporations ranging from Canada Post to Quebec's Société générale de financement. In theory, most of these agencies are meant to be self-supporting. In practice, many accumulate large deficits or unfunded liabilities, which are the responsibility of the government that runs the agency or corporation.

20. How are the prime rate and bank rate connected?

Financial institutions set their prime rates and changes correspond to the change in the Bank Rate. This connection is perhaps the primary method of control regarding monetary policy that the Bank of Canada has - change the target for the overnight rate of interest leads to a change in the lower and upper operating bands. A change to the upper operating band influences the prime lending rate, mortgage rates and other lending rates offered by institutions.

Fiscal policy

Fiscal policy is the use of the government's spending and taxation powers to pursue such economic goals as full employment and sustained long-term growth. They do this by spending more and taxing less when the economy is weak, and by spending less and taxing more when the economy is strong.

Monetary policy

Monetary policy sets out to improve the performance of the economy by regulating the growth in money supply and credit. The goal of monetary policy is to ensure that money can play its vital role in helping the economy run smoothly. Canadian monetary policy strives to protect the value of the Canadian dollar by keeping inflation low and stable. As Canada's central bank, the Bank of Canada achieves this through its influence over short-term interest rates.

Monetary policy and Fiscal policy difference

Monetary policy uses interest rates, exchange rates and the money supply to influence consumer demand and control inflation. Fiscal policy tries to regulate growth through government taxation and spending.

SPRAs The Bank will use SPRAs if it feels there is too much upward pressure on the overnight lending rate. If overnight money is trading above the target operating band, the Bank may believe that the higher rate will dampen economic activity or, in other words, lead to slower growth.

SPRA 1. The Bank intervenes and offers to purchase government securities at the upper limit of the operating band. 2. Purchasing Government of Canada Securities by the Bank of Canada increases the money supply and helps decrease overnight interest rates. 3. The Bank works with a primary dealer (such as a chartered bank) with an agreement to sell the securities back the next day at a predetermined price. For example, when the target rate is 4%, the upper limit of the operating band is 4.25%. If overnight money is trading above the upper limit of the operating band, lets say at 4.50%, it does not make sense for a financial institution to borrow at 4.50% from another financial institution when it can get the upper limit of the operating band of 4.25% from the Bank. It then goes with the Bank 4.25%, preventing the overnight rate from rising above the upper operating band.

SRAs The Bank will use SRAs if it feels there is too much downward pressure on the overnight lending rate. If overnight money is trading below the target of the operating band, the Bank may believe that higher inflation could occur.

SRA 1. The Bank intervenes and offers to sell government securities at the lower limit of the operating band. 2. Selling Government of Canada Securities by the Bank of Canada reduces the money supply and helps increase overnight interest rates. 3. The Bank works with a primary dealer (such as a chartered bank) with an agreement to buy the securities back the next day at a predetermined price. For example, when the target rate is 4%, the lower limit of the operating band is 3.75%. If overnight money is below the lower limit of the operating band, lets say at 3.50%, it does not make sense for a financial institution to lend at 3.50% to another financial institution when it can get the lower limit of the operating band of 3.75% from the Bank. It then goes with the Bank 3.75%, preventing the overnight rate from dropping below the lower operating band.

SRA

Sale and Repurchase Agreements (SRAs) are used to offset undesired downward pressure on overnight financing costs. If overnight money is trading below the target of the operating band, the Bank may believe that inflationary pressures in the economy will rise. To combat this, the Bank intervenes and offers to borrow at the lower limit of the operating band. For this example, if the lower limit of the operating band is 3.75% while overnight money trades at 3.50%, financial institutions would much prefer the Bank of Canada rate. SRAs work as follows: • The Bank offers to sell government securities to chartered banks with an agreement to repurchase them the next day at a predetermined price. • In exchange for the sale, the Bank receives money. Essentially, the Bank is borrowing money from the Chartered Bank when it sells securities under this program. • The next day, the Bank repurchases those securities in exchange for the cash. In effect, the money they borrowed is paid back. This operation is used to reinforce lower the limit or floor of the operating band and is the focus of considerable market attention. On a number of occasions, the offering itself is sufficient to eliminate the downward pressure on the overnight rate. Partly as a result of this, the amounts of SRAs dealt tend to be quite small relative to SPRAs.

SPRA

Special Purchase and Resale Agreements (commonly referred to as SPRAs or "Specials") are used by the Bank of Canada to relieve undesired upward pressure on overnight financing rates. If overnight money is trading above the target of the operating band, the Bank may believe that the higher rate will dampen economic activity. To combat this, the Bank intervenes and offers to lend at the upper limit of the operating band. For example, if the upper limit of the operating band is 4.25% while overnight money trades at 4.50%, it does not make sense for financial institutions to borrow at the higher overnight rate. SPRAs work as follows: • The Bank offers to purchase government securities from a primary dealer (such as a chartered bank) with an agreement to sell them back the next day at a predetermined price. • When the Bank purchases securities from an institution, they pay the institution cash for the securities. Essentially, the cash payment acts as a very short-term loan. • The next day, when the securities are resold to the institution, the Bank receives money in exchange for the securities they are returning. This operation is used to reinforce the upper limit or top end of the overnight target and is closely watched by market participants.

The two main open market operations that the Bank uses to conduct monetary policy are

Special Purchase and Resale Agreements and Sale and Repurchase Agreements.

Bank Rate

The Bank Rate is the minimum rate at which the Bank of Canada will lend money on a short-term basis to the chartered banks and other members of the Canadian Payments Association (CPA) in its role as lender of last resort. It is closely related to the Target for the Overnight Rate because the Bank Rate is the upper limit of the operating band. Continuing with our example from above, with an operating target range of between 5% and 5.5%, the Bank Rate is 5.5%.

Financial advisor to the Government

The Bank advises the Government on the timing of new federal securities issues. It advises on the price, yield and other special features needed to make them marketable. The Bank also advises the Government about where such securities should be sold (i.e., domestically, in the U.S. or offshore). In order to keep abreast of market developments, the Bank conducts regular discussions with investment dealers, bankers and other investors to obtain views and suggestions.

Which of the following allows participating financial institutions to conduct transactions with each other through an electronic wire system? a) Large Value Transfer System b) Canadian Payments System c) Canada Investment and Savings System d) Sale and Repurchase Agreements

The Bank established the Large Value Transfer System (LVTS) to facilitate the transfer and settlement of large transactions between participating financial institutions. The system allows financial institutions to track their LVTS receipts and payments electronically throughout the day.

Debt management

The Bank of Canada acts as the federal Government's fiscal agent in its activities in debt management. The planning and arrangements necessary for a new debt issue are major undertakings. Not only must each issue be distributed and sold, arrangements for payments, transfers of funds, etc., must be made. Then there is regular record keeping, payments of interest, transfers of ownership and finally providing funds to repay the issue at maturity.

What are the two most important ways in which the Bank of Canada influences interest rates?

The Bank of Canada conducts monetary policy through its influence over short-term interest rates. It does this primarily through cash management mechanisms (drawdown redeposit) and open market operations (SPRA and SRA).

18. How often does the Bank of Canada change the operating bands?

The Bank of Canada currently announces the rate eight times per year. The Bank of Canada produces a schedule so that the public knows the exact dates through the year of when the announcements will occur. The target for the overnight rate, and subsequently the operating bands, may or may not change depending on the Bank of Canada's economic perspective. And even though that's the case, the Bank of Canada watches closely on a daily basis and as a daily exercise works toward keeping the rate near the middle of the band through various market operations.

If the Bank of Canada would like to reduce the supply of cash balances in the banking system, what policy action can it take? a) SPRA b) LVTS c) Redeposit d) Drawdown

The Bank of Canada would institute a drawdown. A drawdown refers to the transfer of deposits to the Bank from the chartered banks, effectively draining the supply of available cash balances from the banking system. This decreases deposits and reserves available to the banks in their business. Removing money from the system causes a contraction in the availability of loans to consumers and businesses, which places upward pressure on interest rates.

Role of the Bank of Canada

The duties and role of the Bank are stated in a general way in the preamble of the Bank of Canada Act: • "To regulate credit and currency in the best interests of the economic life of the nation... • To control and protect the external value of the national monetary unit... • To mitigate by its influence fluctuations in the general level of production, trade, prices and employment, as far as may be possible within the scope of monetary action and generally... • To promote the economic and financial welfare of the Dominion."

federal government

The federal government is responsible for such things as employment insurance, defence, old age security, veterans' affairs and native affairs. A large segment of its spending consists of transfer payments to the provincial governments to pay for health, education and welfare. At times, federal deficit reduction efforts result in cuts to these transfers, putting upward pressure on provincial deficits, since the provinces have little other revenue to compensate for the loss of transfers.

DRAWDOWNS AND REDEPOSITS

The federal government maintains accounts with the Bank of Canada and the chartered banks. As the banker for the federal government, the Bank of Canada can transfer funds from the government's account at the Bank to its account at the chartered banks or from the government's account at the chartered banks to its account at the Bank of Canada. This strategy is used to influence short-term interest rates and is achieved using drawdowns or redeposits. • A drawdown refers to the transfer of deposits to the Bank from the chartered banks, effectively draining the supply of available cash balances from the banking system. This decreases deposits and reserves available to the banks to utilize in their business. Removing money from the system causes a contraction in the availability of loans to consumers and businesses, and this places upward pressure on interest rates. • A redeposit is just the opposite, a transfer of funds from the Bank to the chartered banks. This increases deposits and reserves and the availability of funds in the banking system. Adding money to the system places downward pressure on interest and gives banks an incentive to increase loans to consumers and businesses.

The Bank of Canada carries out monetary policy primarily through changes to what it calls the Target for the Overnight Rate.

The overnight rate is the interest rate set in the overnight market - a marketplace where major Canadian financial institutions lend each other money on an overnight basis. When the Bank changes the target for the overnight rate, other short-term interest rates also usually change. Currently, the overnight rate operates within a 50 basis points (or one-half of a percentage point) wide operating band. Each day, the Bank targets the mid-point of the operating band as its key monetary policy objective. For example, if the operating band is 5% to 5.5%, then the target for the overnight rate is 5.25%. Currently, the overnight rate operates within a 50 basis points (or one-half of a percentage point) wide operating band. Each day, the Bank targets the mid-point of the operating band as its key monetary policy objective. For example, if the operating band is 5% to 5.5%, then the target for the overnight rate is 5.25%.

19. What's the difference between the overnight rate, the bank rate and the prime rate?

The overnight rate represents the interest rate at which major participants in the Canadian Payments Association lend one-day funds to each other. The Bank of Canada would like to keep this rate between two operating bands. The upper band represents a level that the overnight lending rate should not exceed. The upper band is also known as the bank rate. The bank rate is the minimum rate at which the Bank of Canada lends money to those that participate in the Canadian Payments Association. The Prime Rate Prime refers to the rate at which banks charge their best customers. If you wanted to rank the rates numerically from highest to lowest: Prime Rate; Upper operating band (also known as the Bank Rate); Target for the overnight rate of interest; Lower operating band.

provincial governments

The provincial governments are responsible for health, education and welfare. However, the federal government shares some responsibility for those areas with the provinces.

Large Value Transfer System (LVTS)

This system allows participating financial institutions to conduct large transactions with each other through an electronic wire system. Among other things, this system permits these financial institutions to track their LVTS receipts and payments electronically throughout the day and to know the net outcome of these flows by the end of the day (same day settlement).

How the LVTS works

This system provides an important setting for conducting monetary policy. Throughout the day, financial institutions in the LVTS send payments back and forth to each other as part of their normal operations. At the end of each day, all of the transactions that occurred during the day are added up, and some financial institutions may end up needing to borrow funds while some may have funds left over.

Since 1991, the Bank has committed to specific inflation-control targets that establish a target range within which it aims to contain annual inflation as measured by the year-over-year rate of increase in the CPI. Currently, the target range extends from 1% to 3%. Here is how the Bank keeps inflation within this range:

• If inflation approaches the top of the target range, this usually indicates that the demand for goods and services is rising too strongly and must be controlled through an increase in short term interest rates. • If inflation falls towards the bottom of the target range, this usually indicates that economic growth is slowing or weakening and support is needed through a decrease in interest rates.

How Fiscal Policy Affects the Economy

• Spending: Governments can purchase goods or services themselves, such as a new highway, thereby boosting economic activity. Or they can simply transfer money to citizens to spend or save themselves, such as with social security cheques. Only the fi rst type is recorded as government spending in GDP. • Taxes: The amount of tax collected may vary because the size of the tax base changed, i.e., the number of people or companies paying the tax expanded or contracted. Also, it can vary because the tax rate changed, so that each dollar of economic activity yields more or less tax. Raising tax rates reduces the disposable income of consumers, thereby dampening their spending. The main types of taxes are: - Direct taxes, levied on the income of individuals and companies; - Sales taxes (including value-added taxes, like the goods and services tax, and excise taxes, such as on liquor); - Payroll taxes, levied as a share of wages; - Capital taxes, levied on the size of a company's assets or capital; - Property taxes, levied on residential and commercial property. All taxes tend to discourage the type of activity being taxed. Income taxes reduce the incentive to work and earn; payroll taxes reduce the incentive to hire; and sales taxes reduce the incentive to spend.

WHAT ARE THE DIFFERENT ECONOMIC THEORIES?

• The rational expectations theory suggests that firms and workers are rational thinkers and can evaluate all the consequences of a government policy decision, thereby neutralizing its intended impact. • Keynesian economics advocates the use of direct government intervention to achieve economic growth and stability. Keynesians believe the use of active fiscal policy, using government spending and taxation, is necessary to stabilize the business cycle. • Monetarist theory suggests that the economy is inherently stable, with its own self adjusting mechanism that automatically moves the economy to a stable path of growth. Monetarists argue against the use of active monetary or fiscal policy and believe the central bank should simply expand the money supply at a rate equal to the economy's long-term growth rate. • Supply-side economics suggests that to foster an environment of prosperity, the market should be left alone and government intervention should be minimal, only occurring through changes in tax rates. This theory maintains that lower government spending and lower taxes provide the stimulus for economic expansion.

The major functions of the Bank of Canada are:

• To act for the Government in the issuance and removal of bank notes; • To act as the Government's fiscal agent (i.e., being the Government's financial advisor on debt management, foreign exchange and monetary policy and acting as its agent in financial transactions); and • To conduct monetary policy (i.e., managing the supply of the nation's money). This is the Bank's most important function. The Bank of Canada Act empowers the Bank to: • Buy and sell gold, silver and foreign exchange; • Maintain deposits with other central banks and commercial banks inside and outside Canada; and • Act as agent and depository for central banks and certain international institutions. The Bank acts as a depository for gold held by the Exchange Fund Account. It also buys and sells gold. This activity has diminished importance reflecting the marginal role of gold in securing the value of the Canadian dollar.