Bank of Canada expects economy to expand in the future

ECON2210 – KPU Copyright: Rabia Aziz Spring Econ2210-HO7-Ch16 Homework Assignment Ch 16/17 1. Bank of Canada expects economy to expand in the future. To prevent inflation from rising, Bank wants to tighten monetary conditions and it raises the operating band from 0.5% – 1% to 0.75% – 1.25% a) identify the initial bank rate, deposit rate and target overnight interest rate: b) identify the new bank rate, deposit rate, and the overnight interest rate target: c)

If during the course of the day overnight funds are trading below the target overnight rate, manager at the trading desk at BoC enters into __________________ (SPRAs or SRAs?) d) Show the effect of the repurchase transaction (as specified by you in c.) on T-accounts of the BoC and Primary Dealer. Assume the transaction is worth $200 million Bank of Canada Primary Dealers (LVTS participants) Assets Liabilities Assets Liabilities e) Assuming no other transaction occurs, what is the effect of the new settlement balances position going to be on the overnight interest rate towards the end of the day? 2)

Assume the Settle Balances are in a deficit position at the end of the day. How does the Bank of Canada neutralizes them? Explain with the help of T-accounts below. Assume SB are in deficit of $200 million Bank of Canada Primary Dealers (LVTS participants) Assets Liabilities Assets Liabilities 4. Using the supply and demand analysis of the market for reserves in Canada, indicate what happens to the overnight interest rate, borrowed reserves, and non-borrowed reserves, holding everthing else constant under the following circumstances:

i. Economy is surprisingly strong, leading to an increase in chequable deposits ECON2210 – KPU Copyright: Rabia Aziz Spring Econ2210-HO7-Ch16 ii. Bank of Canada lowers the target for the overnight interest rate 5. Use the Taylor rule to determine the appropriate setting of the overnight interest rate if the current inflation is 3%, equilibrium overnight interest rate is 2%, target inflation is 2% and there is a positive output gap of 1%. Bonus question: 6 Briefly explain the following: Quantitative Easing vs Credit Easing Forward Guidance Negative Interest Rates on Banks’ Deposits

1.

The Bank of Canada raises its operating band from 0.5%-1% to 0.75%-1.25%. Therefore, the initial bank rate is 0.75%-1.25%, while the deposit rate is 0.5%-1%. The target overnight interest rate can be calculated by adding the bank rate to the deposit rate and dividing it by 2.

In this scenario, the overnight interest rate is 0.625%-1.125% [(0.5+0.75)/2, (1+1.25)/2]

The new bank rate is 1.375%-1.125%, which is derived from the equation [(0.75+0.625), (0.5+0.625)]; while the new deposit rate is 2.25% – 2.5% derived from [(1+1.25), (1.25+1.25)]. The new target overnight interest rate is: [(1.375+2.25)/2, (1.125+2.5%)/2]. From this equation, the overnight interest rate is 1.8125.

If during the day overnight funds trade below the target overnight rate, the BoC manager enters into SRAs, which helps increase the undesired downward pressure.

d.

Effect of Repurchase Transaction on T-accounts of the BoC and Primary Dealer

If no other transaction occurs, the new settlement balance position will likely increase the overnight interest rate towards the end of the day.

2.

The Bank of Canada neutralizes a Settlement balance deficit by auctioning new deposits to direct clearers at the end of the day. Therefore, if the deficit is $200 million, the T-accounts will appear as shown below.

3. An increase in chequable deposits would lower the overnight interest rate and increase the demand for borrowed reserves to enable banks to borrow at a lower rate and settle the deposits’ withdrawals. The increase in chequable deposits would also increase non-borrowed reserves’ supply, which is the amount of cash that banks would hold to settle withdrawals.

ii.

If the Bank of Canada lowers the target for the overnight interest rate, it makes it easier for banks to borrow among themselves. This action increases the demand for borrowed reserves as firms demand more funds to offer to the public in the form of loans. However, the demand for non-borrowed reserves declines as banks opt to loan money borrowed at a low-interest rate to the public and generate higher income from the current market rates.

The Taylor Rule makes two provisions about interest rates. On the one hand, the rule states that the Federal Reserve should raise interest rates if current inflation is above the target and when the GDP is above the potential. The rule also states that the Federal Reserve should lower rates when the inflation rate is lower than the target and when the GDP growth is below the potential.

The Taylor rule formula is: ff^t = π + ff^*r + ½(π gap) + ½(Y gap); where ff^t is federal funds target, π is inflation, ff^*r  is real fed funds rate, π gap is inflation gap, and Y gap is the output gap.

Therefore, the appropriate setting of the overnight interest rate in this scenario should be:

3+ 2+1/2 (1) + ½ (0) = 5.5

5.

1. Quantitative easing is the increase in the bank’s reserves, often on the central bank’s liability side in the balance sheet. In contrast, credit easing is the increase in securities and loans on the central bank’s asset side in the balance sheet.

b.

Forward guidance is a communication by the central bank to households, investors, and businesses on the economy’s future state. Forward guidance aims at influencing the public’s financial decisions.

A negative interest rate on bank deposits is a state at which the central bank sets the nominal interest rate lower than zero percent to encourage borrowing and investment.

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