Final Exam money, banking, finance

The bank of Canadas policy rate

- Overnight interest rate The interest rate at which participants borrow and lend overnight funds to each other in the money market - The reference rate The Bank of Canada signals its monetary policy stance by announcing a target for the overnight interest rate - The policy rate The target for the overnight rate which is the main tool the Bank uses to conduct monetary policy

The operating band for the overnight rate

- The Bank's objective is to keep the overnight rate within a band of 50 basis points (1/2 of 1%) - In response to the subprime financial crisis, the Bank of Canada temporarily narrowed the operating band for the overnight interest rate to 25 basis points (1/4 of 1%) - The Bank operates under a system of eight "fixed" dates throughout the year for announcing changes to the operating band

Non - LVTS (ACCSS) 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 - The Direct Clearers are subset of LVTS participants who participate directly in the ACSS

· Lessons for monetary policy

Four basic lessons: § It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates § Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms § Monetary policy can be effective in reviving a weak economy even if short-term interest rates are already near zero § Avoiding unanticipated fluctuations in the price level is an important objective of monetary policy, thus providing a rationale for price stability as the primary long-run goal for monetary policy

Critique of the Simple Model

Holding cash stops the process -Currency has no multiple deposit expansion Banks may not use all of their excess reserves to buy securities or make loans Depositors' decisions (how much currency to hold) and bank's decisions (amount of excess reserves to hold) also cause the money supply to change

· Tactics: The Taylor Rule

Overnight interest rate = inflation rate + equilibrium overnight rate + ½ (inflation gap) + ½ (output gap) o An inflation gap and an output gap o Stabilizing real output is an important concern o Output gap is an indicator of future inflation as shown by Phillips curve o NAIRU o Rate of unemployment at which there is no tendency for inflation to change

The three players in the money supply process include

The central bank, banks (depository institutions), depositors

· Systematic risk and the LVTS

The risk to the entire payments system due to the inability of one financial institution to fulfill its payment obligations The LVTS helps eliminate systemic risk 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

· Foreign exchange market

`o Exchange rate: price of one currency in terms of another o Foreign exchange market: the financial market where exchange rates are determined o Spot transaction: immediate (two-day) exchange of bank deposits § Spot exchange rate o Forward transaction: the exchange of bank deposits at some specified future date § Forward exchange rate o Appreciation: a currency rises in value relative to another currency o Depreciation: a currency falls in value relative to another currency o When a country's currency appreciates: § The country's goods abroad become more expensive § Foreign goods in that country become less expensive o Over-the-counter market: mainly banks

bank of Canada balance sheet ASSETS

`§ Government securities: holdings by the Bank of Canada that affect money supply and earn interest § Loans to financial institutions: provide loans (advances) to banks and charge the bank rate

· Functions of the bank of Canada

currency, funds management, financial system, monetary policy

· Intervention in the foreign exchange market

o A central bank's purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base o A central bank's sale of domestic currency to purchase foreign assets results in an equal rise in its international reserves and the monetary base

· Nominal anchor

o A nominal variable such as the inflation rate or the money supply, which ties down the price level to achieve price stability

· The time inconsistency problem

o A subtle reason for a nominal anchor's importance is that it can limit the time-inconsistency problem § Monetary policymakers tempted to pursue a discretionary monetary policy that is more expansionary to boost economic output (or lower unemployment) in the short run § Workers and firms raise their expectations about inflation, driving wages and prices up Rise in wages and prices will lead to higher inflation, but will not result in higher output

· Monetary unions

o A variance of a fixed exchange rate regime is a monetary (or currency) union § Group of countries decide to adopt a common currency o Earliest monetary union was in 1787, when the 13 American colonies formed the United States o More recently, the European Monetary Union was formed in January 1999 § 11 initial member countries adopted the Euro o Eases trade across borders, but countries no longer have independent monetary policy

· Inflation targeting

o Advantages § Reduces potential of falling in time-inconsistency trap § Stresses transparency and accountability § Consistent with democratic principles § Improved performance o Disadvantages § Delayed signaling § Too much rigidity § Potential for increased output fluctuations § Low economic growth during disinflation

· Dollarization

o Alternative to currency board is to adopt another country's money (like the U.S. dollar) o Even stronger commitment mechanism o Completely avoids possibility of speculative attack on domestic currency o Loss of independent monetary policy and increased exposure to shocks from anchor country o Inability to create money and act as lender of last resort o Loss of Seignorage

· Forward guidance and the commitment to future policy actions

o Although short-term interest rates could be at zero, central banks can take different routes to lower long-term rates o In particular, they can make commitments to keep policy rates at zero for a long period of time § Lowers expectations of future short-term rates § Commonly referred to as forward guidance § Can be conditional or unconditional

· Exchange rates in the short run: a supply and demand analysis

o An exchange rate is the price of domestic assets in terms of foreign assets o Supply curve for domestic assets § Assume amount of domestic assets is fixed (supply curve is vertical) o Demand curve for domestic assets § Most important determinant is the relative expected return of domestic assets § At lower current values of the dollar (everything else equal), the quantity demanded of dollar assets is higher

· Traditional interest rate channels

o An important feature of the interest-rate transmission mechanism is its emphasis on the real (rather than the nominal) interest rate as the rate that affects consumer and business decisions o In addition, it is often the real long-term interest rate (not the real short-term interest rate) that is viewed as having the major impact on spending § Especially purchases of durable items

· Should central banks try to stop asset price bubbles?

o Asset-price bubble § Pronounced increase in asset prices that depart from fundamental values, which eventually burst o Types of asset-price bubbles § Credit-driven bubbles § Bubbles driven solely by irrational exuberance

· The debate: Con (should not prick asset price bubbles)

o Asset-price bubbles are nearly impossible to identify o Raising interest rates to diminish asset-price increases may not be effective o Many different asset prices exist, and monetary policy is too blunt of an instrument o Monetary policy actions to prick bubbles can have harmful effects on the aggregate economy o As long as policymakers respond in a timely fashion, the harmful effects of a bursting bubble are manageable

· The bank of Canadas standing facilities

o At the end of each banking day, each LVTS participant must bring its settlement balance with the Bank close to zero o The Bank of Canada therefore stands ready (with standing liquidity facilities) to lend to or borrow from a participant to bring their settlement balances to zero at the end of the banking day o Participants know with certainty the rates applicable to positive and negative settlement balances o The initiative is on the side of the LVTS participant § Participant may use the Bank's lending facility to obtain overnight liquidity in case of a shortage, or § Participant may use the deposit facility to make deposits in case of excess liquidity

· Settlement balances management

o Bank of Canada also targets the level of settlement balances in the system o Typically, target level is announced the previous day o Bank neutralizes the impact on settlement balances via open-market buyback operations o Bank neutralizes SRA operations as well o Shifts (transfers) of government deposits § Transfer deposits from banks to Bank of Canada: drawdowns § Transfer deposits from Bank of Canada to banks: redeposits

· Repurchase transactions

o Bank of Canada stopped conducting open market operations in Government T-bills in 1994, instead uses: o Repos or Specials § Special Purchase and Resale Agreements (special PRAs or SPRAs) § Used as a tool to reduce undesired upward pressure on the overnight interest rate o Reverse Repos or Reverses § Sale and Repurchase Agreements (SRAs) § Used as a tool to reduce undesired downward pressure on the overnight rate

· Nominal interest rates and monetary policy

o Bank of Canada uses nominal overnight interest rate as operating instrument o Effects on the monetary policy on economic activity are from the real interest rate affecting consumption and investment o Short-term nominal rates affect short and long-term real interest rates under assumption of sticky prices

· Bank of Canada lending

o Bank stands ready to lend overnight settlement balances to LVTS participants with negative clearing balances o Lending rate is ib o Large increase in demand for reserves shifts demand right and equilibrium ior increases o At ib, the standing lending facility puts ceiling on overnight rate

resrves

o Banks (LVTS participants), have an account at the Bank of Canada in which they hold deposits (also called settlement balances) o Reserves consist of settlement balances at the Bank of Canada plus vault cash o Banks hold reserves in order to manage liquidity

· The debate: Pro (central banks should pop bubbles)

o Bursting of credit-driven bubbles can not only be extremely costly, but also very hard to clean up o Recent financial crisis demonstrates this o Bubbles can occur even if price and output stability exist in the period leading up to them o Lean versus clean debate may have been miscast o Rather than leaning against potential bubbles, lean against credit booms

· Application effects of changes in interest rates on the equilibrium exchange rate

o Changes in Interest Rates § When domestic real interest rates raise, the domestic currency appreciates § When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreciates o Changes in the Money Supply § A higher domestic money supply causes the domestic currency to depreciate

factors that determine the money supply

o Changes in the nonborrowed monetary base MBn o The money supply is positively related to the non-borrowed monetary base MBn o Changes in borrowed reserves from the Bank of Canada o The money supply is positively related to the level of borrowed reserves, BR, from the Bank of Canada o Changes in the desired reserves ratio § The money supply is negatively related to the required reserve ratio o Changes in currency holdings § The money supply is negatively related to currency holdings o Changes in excess reserves § The money supply is negatively related to the amount of excess reserves

· How monetary policy affects the economy

o Changes in the overnight rate influences other interest rates and the exchange rate o The level of short term interest rates and the exchange rate of the Canadian dollar determine the monetary conditions in which the economy operates

· Wealth effects

o Consumption is spending by consumers on nondurable goods and services o An important component of consumers' lifetime resources is their financial wealth, a major component of which is common stocks o When stock prices rise, the value of financial wealth increases, thereby increasing the lifetime resources of consumers, and consumption should rise

· Capital controls

o Controls on outflows § Promote financial instability by forcing a devaluation § Controls are seldom effective and may increase capital flight § Lead to corruption § Lose opportunity to improve the economy o Controls on inflows § Lead to a lending boom and excessive risk taking by financial intermediaries § Controls may block funds for productions uses § Produce substantial distortion and misallocation § Lead to corruption

· Credit view

o Credit View is the new explanation based on the problem of asymmetric information in financial markets that leads to financial frictions o It proposes that two types of monetary transmission channels arise as a result of financial frictions in credit markets: § Those that operate through effects on bank lending § Those that operate through effects on firms' and households' balance sheets

· How is foreign exchange traded?

o Currencies are not traded on exchanges such as the Toronto Stock Exchange o Instead, the foreign exchange market is organized as an over-the-counter (OTC) market § Several hundred dealers (mostly banks) stand ready to buy and sell assets denominated in foreign currencies § Very competitive o For small transactions, there is a retail market for foreign exchange (say, the Thomas Cook store) § Retail prices are higher than wholesale

· Lessons for monetary policy strategy from the global financial crisis

o Developments in the financial sector have a far greater impact on economic activity than was earlier realized o The zero-lower-bound on interest rates can be a serious problem o The cost of cleaning up after a financial crisis is very high o Price and output stability do not ensure financial stability

· International considerations and monetary policy

o Direct Effects of Foreign Exchange on Monetary Policy § Conducting monetary policy is easier when a country's currency is a reserve currency (like the U.S.) o Balance of payment considerations § Current account deficits in the U.S. suggest that American businesses may be losing ability to compete because the dollar is too strong § U.S. deficits mean surpluses in other countries à large increases in their international reserve holdings à world inflation o Exchange rate considerations: § A contractionary monetary policy will raise the domestic interest rate and strengthen the currency § An expansionary monetary policy will lower interest rates and weaken currency

Application: quantative easing and the money supply, 2007 - 2014

o During the financial crisis the monetary base more than tripled as a result of the Fed's purchase of assets and new lending facilities to stem the financial crisis o The currency ratio fell during this period o Money supply model suggests that would raise the money multiplier and the money supply because it would increase the overall level of deposit expansion o However, the effects of the decline in c were entirely offset by the extraordinary rise in the excess reserves ratio e

· Transmission mechanism of monetary policy

o Examines whether one variable affects another by using data to build a model that explains the channels through which the variable affects the other o Transmission mechanism § The change in the money supply affects interest rates § Interest rates affect investment spending § Investment spending is a component of aggregate spending (output)

Exchange rate effects on net exports

o Exchange rates are affected by interest rates § When real rates fall, domestic dollar assets become less attractive, so the dollar depreciates o Lower value of domestic currency makes domestic goods cheaper than foreign goods o Net exports rise, and therefore aggregate demand rises as well

· When is exchange rate targeting desirable

o Exchange-rate targeting for industrialized countries is desirable if: § Domestic monetary and political institutions are not conducive to good policy making § Other important benefits such as integration arise from this strategy o Exchange-rate targeting for emerging market countries is desirable if: § Political and monetary institutions are weak § Strategy becomes the stabilization policy of last resort

· Quantitative easing versus credit easing

o Expansion of central bank balance sheets is referred to as quantitative easing § It leads to a huge increase in the monetary base o Will this stimulate the economy in the near term and produce inflation down the road? § Balance sheet expansion does not necessarily increase the money supply, since excess reserves can increase § Short-term rates are at zero lower bound

· Monetary policy tools of the federal reserve

o Federal Funds Rate o Open Market Operations o Discount Lending o Required Reserves o Interest on Reserves

· Application applying the monetary policy lessons to japan

o First lesson: dangerous to think declines in interest rates mean that monetary policy has been easing o Second lesson: monetary policymakers should pay attention to other asset prices in assessing the stance of monetary policy o Third lesson: monetary policy can still be effective even if short-term interest rates are near zero o Fourth lesson: unanticipated fluctuations in the price level should be avoided

· Other goals of monetary policy

o Five other goals are continually mentioned by central bank officials when they discuss the objectives of monetary policy: § High employment and output stability · The natural rate of unemployment § Economic growth § Stability of financial markets § Interest-rate stability § Stability in foreign exchange markets

· Exchange rate regimes in the international system

o Fixed exchange rate regime Value of a currency is pegged relative to the value of one other currency (anchor currency) o Floating exchange rate regime Value of a currency is allowed to fluctuate against all other currencies o Managed float regime (dirty float) Attempt to influence exchange rates by buying and selling currencies

· Exchange rate regimes in the international financial system

o Gold standard § Fixed exchange rates § No control over monetary policy § Influenced by production of gold and discoveries o Bretton Woods System § Fixed exchange rates using U.S. dollar as reserve currency § International Monetary Fund § World Bank § General Agreement on Tariffs and Trade (GATT) o European Monetary System (EMS) § Exchange rate mechanism

· Should price stability be the primary goal of monetary policy

o Hierarchical Versus Dual Mandates § Hierarchical mandates put price stability first, and then say that as long as it is achieved other goals can be pursued § Dual mandates are aimed to achieve two coequal objectives: price stability and maximum employment o Price Stability as the primary, long-run goal of monetary policy o Either type of mandate is acceptable as long as it operates to make price stability the primary goal in the long run, but not the short run

· Managed float

o Hybrid of fixed and flexible § Small daily changes in response to market § Interventions to prevent large fluctuations o Appreciation hurts exporters and employment o Depreciation hurts imports and stimulates inflation o Special drawing rights as substitute for gold

· The bank of Canada and the operating band

o If the overnight rate increases toward the upper limit of the operating band § The Bank will lend at the bank rate § Puts a ceiling on the overnight rate o If the overnight rate falls toward the lower limit of the operating band § The Bank will accept deposits from LVTS participants at the bank rate less 50 basis points § Puts a floor on the overnight rate

· Household liquidity effects

o If, as a result of a bad income shock, consumers needed to sell their consumer durables or housing to raise money, they would expect a big loss because they could not get the full value of these assets in a distress sale o In contrast, if consumers held financial assets (such as money in the bank, stocks, or bonds), they could easily sell them quickly for their full market value and raise the cash

Long run factors that affect exchange rates

o In general, if a factor increases the demand for domestic goods relative to foreign goods then the domestic currency will appreciate § Relative price levels: higher prices leads to depreciation § Trade barriers: Higher tariffs leads to appreciation § Preferences for domestic versus foreign goods: increased demand for a country's exports leads to appreciation § Productivity: higher productivity leads to appreciation

· Nonconventional monetary policy tools

o In normal times, conventional policy tools are enough o In time of financial crisis, they are no longer effective § The financial system seizes up to such an extent that it becomes unable to allocate capital § The negative shock to the economy can lead to the zero-lower-bound problem, where the central bank is unable to lower short-term interest rates o Central banks therefore need non-interest-rate tools known as nonconventional monetary policy tools

· The role of the IMF

o International lender of last resort o Emerging market countries with poor central bank credibility and short-run debt contracts denominated in foreign currencies have limited ability to engage in this function o May be able to prevent contagion o The safety net may lead to excessive risk taking (moral hazard problem)

· Implications for inflation targeting

o Level of the inflation target § Central banks typically target inflation around the 2% level § Seriousness of the zero-lower-bound problem raises the question of whether this target level is too low § But, it can be harder to stabilize inflation at higher levels o Flexibility if inflation targeting § Financial instability can have devastating effects on the economy and that achieving price and output stability does not ensure financial stability § Central banks need to pay more attention to financial stability in any monetary policy framework

Control of the monetary base

o MB = C + R o MB: monetary base (high-powered money) o C: currency in circulation (notes and coins held by the public outside banks) o R: total reserves in the banking system (vault cash + settlement balances) o The Bank of Canada controls the monetary base through open market operations and advances to banks

Policies to restrain credit driven bubbles

o Macropudential policy § Regulatory policy to affect what is happening in credit markets in the aggregate o Monetary policy § Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction § Low interest rates may increase the incentives for asset managers to search for higher yields and take higher risks

· How should the IMF operate?

o May not be tough enough o Austerity programs focus on tight macroeconomic policies rather than financial reform o Too slow, which worsens crisis and increases costs o Countries were restricting borrowing from the IMF until the recent subprime financial crisis

· Inflation targeting in New Zealand, Canada, and the United Kingdom

o New Zealand (effective in 1990) § Inflation was brought down and remained within the target most of the time. § Growth has generally been high and unemployment has come down significantly o Canada (1991) § Inflation decreased, some costs in term of unemployment o United Kingdom (1992) § Inflation has been close to its target. § Growth has been strong and unemployment decreasing

· Supply curve

o Non-borrowed (NBR) and borrowed reserves (BR) o Cost of borrowing from Bank of Canada is the bank rate (ib) o Borrowing from Bank of Canada is a substitute for borrowing from other banks o If ior< ib, then banks will not borrow from the Bank of Canada and borrowed reserves are zero o Supply curve will be vertical o As ior rises above ib, banks will borrow more and more at ib, and re-lend at ior o Supply curve is horizontal (perfectly elastic) at ib

· Large scale asset purchases

o Normally, open market operations involve only the purchase or sale of government securities (particularly short-term securities) o During the global financial crisis, central banks expanded the range of assets they purchased § In November 2008, the Federal Reserve purchased $1.25 trillion of mortgage-backed securities § In November 2010, the Fed began purchasing $600 billion in long-term U.S. Treasury securities

· Criteria for choosing the policy instrument

o Observability and Measurability § Quick, accurate measurement is necessary o Controllability § Cannot set short-term real interest rates, for example o Predictable effect on Goals § Link between interest rates and inflation is likely much tighter than the link between monetary aggregates and inflation

· Monetary policy tools of the European central bank

o Open market operations § Main refinancing operations § Longer-term refinancing operations o Lending to banks § Marginal lending facility/marginal lending rate § Deposit facility o Reserve Requirements § 2% of the total amount of checking deposits and other short-term deposits § Pays interest on those deposits so cost of complying is low

· Open market operations

o Open market operations are an important monetary policy tool for many central banks o Open market purchases: § Expand bank reserves and the monetary base § Lower short-term interest rates § Raise the money supply o Open market sales: § Shrink bank reserves and the monetary base § Raise short-term interest rates § Lower the money supply

· Overview of the bank of Canadas ability to control the monetary base

o Open market operations are controlled by the Bank of Canada o The Bank of Canada cannot determine the amount of borrowing by banks from the Bank of Canada o Split the monetary base into two components MBn= MB - BR o The money supply is positively related to both the non-borrowed monetary base MBn and to the level of borrowed reserves, BR, from the Bank of Canada

· Tactics: choosing the policy instrument

o Policy instrument (operating instrument) § A variable that responds to the central bank's tools and indicates the stance (easy or tight) of monetary policy o Types: § Reserve Aggregates · Total reserves, nonborrowed reserves, the monetary base, and the nonborrowed base § Interest Rates · Overnight interest rate and other short-term interest rates o Policy instrument might be linked to an intermediate target o Intermediate targets stand between the policy instrument and the goals of monetary o Not as directly affected by the tools of monetary policy, but might be more closely linked to the goals of monetary policy

· The price stability goal

o Policy makers aware of the social and economic costs of inflation o Goal of monetary policy is increasingly views as low and stable inflation, which is what central bankers define as price stability

· Inflation targeting

o Public announcement of medium-term numerical target for inflation is inflation targeting o Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal o Information-inclusive approach in which many variables are used in making decisions o Increased transparency of the strategy o Increased accountability of the central bank

· Structure of the bank of Canada

o Responsibility for the operation of the Bank rests with a Board of Directors, which consists of fifteen members: § The Governor (who is also the chief executive officer and chairman of the Board of Directors) § The Senior Deputy Governor § The Deputy Minister of Finance § Twelve outside Directors o The Board appoints the governor and senior deputy governor with the government's approval, for a renewable term of 7 years o The outside directors are appointed by the minister of finance, with cabinet approval, for a 3-year term o The Governing Council is chaired by the governor and is composed of the senior deputy governor and four deputy governors

· Explaining changes in exchange rates

o Shifts in the demand for domestic assets § Domestic interest rate · Increased domestic interest rates increase the demand for domestic assets and therefore appreciates the currency § Foreign interest rate · Increased foreign interest rates decrease the demand for domestic assets and therefore depreciates the currency § Expected future exchange rate · Rise in expected future exchange rate increases the demand for domestic assets and therefore appreciates the currency

· Currency boards

o Solution to lack of transparency and commitment to target o Domestic currency is backed 100% by a foreign currency o Note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate o Money supply can expand only when foreign currency is exchanged for domestic currency o Stronger commitment by central bank o Loss of independent monetary policy and increased exposure to shock from anchor country o Loss of ability to create money and act as lender of last resort

· Liquidity provisions

o The Bank of Canada introduced new tools during the financial crisis to address aggregate system liquidity issues o Term Purchase and Resale Agreements (Term PRAs) § Term longer than one day; typically, 28 business days o Term Securities Lending § Increases supply of high-quality securities that could be used for collateral

· Lender of last resort

o The Bank of Canada is important in preventing financial panics o Acts as lender of last resort o Provides emergency lending assistance (against eligible collateral) for maximum of 6 months o Prevents bank failures and financial panics o Why not just rely on CDIC? § CDIC insurance fund is small fraction of total deposits § Large-denomination deposits are not guaranteed by CDIC

· Origins of the bank of Canada

o The Bank was created by the Bank of Canada Act in 1934 and started operations in 1935 o Initially the Bank was a private institution but was nationalized in 1938, so is now a national institution with headquarters in Ottawa o Unlike a private bank that operates in pursuit of profit, the Bank of Canada is responsible for the country's monetary policy and for the regulation of Canada's deposit-based financial institutions

· The federal funds rate

o The Fed's lending of reserves to banks is called discount window lending o The interest rate charged banks for these loans is called the discount rate o The primary indicator of the stance of monetary policy in the United States is the federal funds rate, the interest rate on overnight loans of reserves (known as federal funds) that banks trade among themselves

· Thar large value transfer system (LVTS)

o The Large Value Transfer System (LVTS) § Electronic, real-time net settlement network § Designed to provide immediate finality and settlement to time-critical transactions o The LVTS participants know in real time their large-value, wholesale transactions (over $50,000) o Transactions account for < 1% of the total number of transactions but 94% of the value o 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

· Exchange rates in the long run

o The Law of One Price § If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be the same throughout the world no matter which country produces it o Theory of Purchasing Power Parity § All goods are identical in both countries § Trade barriers and transportation costs are low § Many goods and services are not traded across borders

· Balance of payments

o The balance of payments is a bookkeeping system used to record international receipts and payments o The current account shows transactions that involve currently produced goods and services § Exports less imports is the trade balance § Also: investment income, service transactions, transfers o The capital account show net receipts from capital transactions Current account + capital account = net change in government international reserves

· The market for settlement balances

o The market for settlement balances (reserves) is where the overnight interest rate is determined o Market for reserves can be described in a symmetric channel/corridor system of interest-rate control o Demand and Supply in the Market for Reserves o Market equilibrium where the quantity of reserves demanded equals the quantity of reserves supplied determines the overnight rate

· FYI consumers balance sheets and the great depression

o The years between 1929 and 1933 witnessed the worst deterioration in consumers' balance sheets ever seen in the United States o Because of the decline in the price level in that period, the level of real debt consumers owed also increased sharply (by over 20%) o Consequently, the value of financial assets relative to the amount of debt declined sharply, increasing the likelihood of financial distress

· Tobin's q Theory

o Theory that explains how monetary policy can affect the economy through its effects on the valuation of equities (stock) o Defines q as the market value of firms divided by the replacement cost of capital § If q is high, the market price of firms is high relative to the replacement cost of capital, and new plant and equipment capital is cheap relative to the market value of firms § When q is low, firms will not purchase new investment goods because the market value of firms is low relative to the cost of capital

Why are credit channels likely to be important?

o There are three reasons to believe that credit channels are important monetary transmission mechanisms: o A large body of evidence on the behavior of individual firms supports the view that financial frictions of the type crucial to the operation of credit channels do affect firms' employment and spending decisions o There is evidence that small firms (which are more likely to be credit-constrained) are hurt more by tight monetary policy than large firms, which are unlikely to be credit-constrained The asymmetric information view of credit market imperfections is a theoretical construct that has proved useful in explaining many other important phenomena, such as why many of our financial institutions exist, why our financial system

· To peg or not to peg

o There are various monetary policy strategies to achieve price stability (such as inflation targeting) o Another strategy uses foreign exchange as a nominal anchor; this is called exchange-rate targeting o Advantages of Exchange-Rate Targeting: § Contributes to keeping inflation under control § Automatic rule for conduct of monetary policy § Simplicity and clarity o Disadvantages of exchange-rate targeting § Cannot respond to domestic shocks and shocks to anchor country are transmitted § Open to speculative attacks on currency § Weakens the accountability of policymakers as the exchange rate loses value as signal

· Why are exchange rates important?

o They affect the relative price of domestic and foreign goods § If the price of French wine is 1000 Euros, and the exchange rate is $1.32 CDN/EUR, then the wine costs $1320 § If the Euro appreciates to $1.50 CDN/EUR, then the same wine costs $1500, even if its price in Euros is unchanged o When a country's currency appreciates, the country's goods abroad become more expensive and foreign goods in that country become cheaper

other two factors that affect the monetary base

o Two important items that affect the monetary base but are not controlled by the Bank of Canada § Float § Government deposits at the Bank of Canada o Interventions in the foreign exchange market o Although technical and external factors complicate control of the monetary base, they do not prevent the Bank of Canada from accurately controlling it

· Quantitative easing versus credit easing

o Was nonconventional monetary policy actions during the crisis therefore ineffective? o Former Fed Chair Ben Bernanke argues no o Fed's policies were directed not at expanding the balance sheet of the Fed, but rather at credit easing o Alters the composition of the Fed's balance sheet in order to improve the functioning of particular segments of the credit markets o Liquidity helps unfreeze particular markets and increases demand for certain securities and lowers rates (i.e., long-term)

· How a fixed exchange rate regime works

o When the domestic currency is overvalued, the central bank must § Purchase domestic currency to keep the exchange rate fixed (it loses international reserves), or § Conduct a devaluation o When the domestic currency is undervalued, the central bank must § Sell domestic currency to keep the exchange rate fixed (it gains international reserves), or § Conduct a revaluation

Demand curve

o When the overnight rate is above the interest rate paid on excess reserves, ier: § The overnight rate decreases § The opportunity cost of holding excess reserves falls § The quantity of reserves demanded rises o When the overnight rate is below the interest rate paid on excess reserves ier : § Banks keep on adding to their holdings of excess reserves indefinitely o Downward sloping demand curve becomes flat (infinitely elastic) at ier

money multiplier

o define money as currency plus chequable deposits: M1+ o Link the money supply (M) to the monetary base (MB) and let m be the money multiplier o The relationship is described by the following equation: o M = m x MB

· Unsterilized foreign exchange intervention

o foreign assets o Leads to: § Increased international reserves § Increased money supply § Depreciated domestic currency

o Bank Lending Channel

§ Based on the analysis that demonstrates that banks play a special role in the financial system because they are especially well suited to solve asymmetric information problems in credit markets

bank of Canada balance sheet liabilities

§ Currency in circulation: in the hands of the public § Reserves: deposits (settlement balances) at the Bank of Canada and vault cash - these are particularly important for our analysis

o Balance Sheet Channel

§ Like the bank lending channel, the balance sheet channel arises from the presence of financial frictions in credit markets

excess reserves

§ Reserves in excess of desired reserves

Desired reserves

§ Reserves that are held to meet the central bank's requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves

Desired reserve ratio

§ The fraction of deposits that the bank desires be kept as reserves

o Cash Flow Channel

§ another balance sheet channel operates by affecting cash flow, the difference between cash receipts and cash expenditures

o Unanticipated Price Level Channel

§ another balance sheet channel operates through monetary policy effects on the general price level

§ Currency

· Before the creation of the Bank, the federal government and the early banks issued notes · By 1945 the Bank had a monopoly over note issue in the country · The Bank also conducts ongoing research o To improve cost-effectiveness o Increase the durability of bank notes o Reduce counterfeiting