Chapter 20

Monetary Policy Tools

Monetary Policy Tools• The central bank has 3 main tools (AKA

operating instruments) to conduct monetary policy.

1. Asset Market Transactions• Open Market Operations• Currency Market Operations

2. Discount Window Lending

3. Reserve Requirements

• Monetary policy tools are used to manipulate interbank lending market.

Interbank Market• Banks must keep clearing balances at the

central bank but balances are small relative to overall size of demand deposits.

• Large size of demand deposits makes it difficult to predict clearing balance requirements at any time. Banks make up short-fall by borrowing in interbank market.

• Banks with too many reserves can earn interest by lending to banks with too few.

Interest Rates in Interbank Markets

USA Federal Funds Rate

Japan Call Money Bank

HK HIBOR

EU Overnight Cash Rate

UK Repo Rate

Model of Interbank Market

• Supply – Clearing balances are a liability of the central bank. They supply balances and set the overall supply of balances.

• Demand - Clearing balances are an asset of the authorized institutions. They determine how much they want to hold. If the HIBOR is high, they will want to lend their own balance to other banks and hold small reserves in their own account.

Interbank Market

S

D

iIB

Clearing Balances

i*

Asset Market Transactions

• When the central bank purchases assets from banks, it credits their reserve accounts. This increases the aggregate supply of reserves and reduces the equilibrium interest rate.

• When the central bank sells assets to banks it debits their reserve accounts. This reduces the supply of reserve and increases

Open Market Purchase

S

D

iIB

Clearing Balances

i*

i**

S´

1

2

Open Market Sale

S

D

iIB

Clearing Balances

i*

i**

S´

1

2

What shifts the demand for reserves

• Demand for Money – When households want to hold liquid assets, they hold liquid bank deposits. When bank deposits go up, demand for bank reserves go up.

• Reserve Requirements – When regulations require banks to hold a high share of reserves relative to deposits, demand for reserves goes up.

• Liquidity Risk – When the financial institutions want to hold liquidity, demand for liquidity goes up.

Demand for Liquidity Rises

S

D

iIB

Clearing Balances

i*

D´

i**

1

2

Demand for Liquidity Falls

S

D

iIB

Clearing Balances

i*

D´

i**

1

2

Discount Window

• In normal times, banks adjust reserves through asset market transactions.

• Banks also lend reserves to banks who for some reason do not borrow reserves from other banks through the discount window.

• Central bank chooses a discount rate to charge for loans (in EU called Managed Lending Facility).

• Discount rate is chosen by the central bank and is set at a level above what the interbank lending rate was in the recent past.

Interbank Market w/ discount window

S

D

iIB

Clearing Balances

i*

iDW

Demand for Liquidity Increases Suddenly

S

D

iIB

Clearing Balances

i*

iDW

D´

BR

NBR

1

2

Sharp increase in demand for liquidity

Non Borrowed Reserves USA

0.000

0.500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

Jan-01

Feb-01

Mar-01

Apr-01

May-01

Jun-01

Jul-01

Aug-01

Sep-01

Oct-01

Nov-01

Dec-01

Jan-02

Feb-02

Bill

ion

US

$

Automatic Pilot (under full credibility)

• When banks sell HK dollars and buy US dollars, the aggregate balance will shrink.

• This will increase the HIBOR rate. Given equivalent risk, liquidity, and information characteristics of HIBOR and Fed Funds, if HIBOR exceeds Fed Funds, people will sell US dollars and buy clearing balances.

• Supply of balances should move elastically so interest rate is always at Fed Funds rate.

Discount Window

• In September 1998, HKMA offered facility to borrow reserves overnight through repos with Exchange Fund

• Discount Rate– Base Rate: 150 points over Fed Funds Rate

or 5 day moving average of HIBOR whichever is greater.

– Base Rate + 500 basis points if bank borrows more than 50% of Exchange Fund holdings.

Interbank Market w/ discount window

S

D

iIB

Clearing Balances

iFF

iDW

HIBOR vs. Fed Funds

Interbank Rates

0

2

4

6

8

10

12

14

16

18

20

Jun-

86

Jun-

87

Jun-

88

Jun-

89

Jun-

90

Jun-

91

Jun-

92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Jun-

03

Jun-

04

%

Fed Funds HIBOR

Interbank Market w/ discount window

S

D

iIB

Clearing Balances

iFF

iDW

1

2

Automatic Pilot: Demand for Reserves go up/ Supply of

Reserves goes up

• When the demand for reserves goes up, banks can earn more lending money in the HK$ interbank market than the US$. They should sell US$ for HK$ bank reserves.

• When US interest rates rise, the discount window rate also rises.

Fed funds rate rises.

S

D

iIB

Clearing Balances

iFF

iDW

Interest Parity & Credibility• Assuming equivalent

characteristics of US$ & HK$ bonds, we should see uncovered interest parity.

• If market expects a constant exchange rate then interest rates should be equal.

• If market expects a future devaluation, domestic interest rates will be above foreign rates.

• If market expects a future revaluation, domestic interest rates will be below foreign rates.

eHK US EX

i iEX

0e

HK USEXi i

EX

0e

HK USEXi i

EX

0e

HK USEXi i

EX

Expectation of Revaluation

eFF EXi

EX

S

D

iIB

Clearing Balances

iFF

iDW

0eEX

EX

Problems with Automatic Pilot

• Spot exchange markets transactions are cleared two business days after deal.

• Ex. If banks sell their HK dollars to HKMA in exchange for US dollars, the Aggregate Balances will decline. This will lead to high interest rates in the Interbank market.

• Automatic Pilot: Banks buy HK dollars to take advantage of these high interest rates. However, HK dollars not delivered for two days. High interbank rates for two days.

Double Play• Small size of aggregate balances relative

to money supply make system subject to manipulation in 1998,

• Allegations: Hedge funds sold HSI futures short. Then made large sale of HK dollars for US dollars. Result: Sharp rise in HIBOR and a fall in the stock market.

• Government opened discount window as a way of making liquidity available quickly.

Double Play w/ Discount Window

S

D

iIB

Clearing Balances

iFF

iDW

HK Interbank Market and Expectations of Revaluation

Aggregate Balances

0

10000

20000

30000

40000

50000

60000

Mil

lio

n H

K$

HIBOR - FF

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

Jan-

02

Mar

-02

May

-02

Jul-0

2

Sep

-02

Nov

-02

Jan-

03

Mar

-03

May

-03

Jul-0

3

Sep

-03

Nov

-03

Jan-

04

Mar

-04

May

-04

Jul-0

4

Sep

-04

Nov

-04

Jan-

05

Mar

-05

May

-05

Jul-0

5

Sep

-05

%

Reserve Requirements

• In Hong Kong, no reserve requirements.• Canada, New Zealand, Australia,

Switzerland have dropped reserve requirements entirely.

• In Europe, reserves pay interest. • USA, reserve requirements apply only to

checkable deposits. • China adjusts monetary policy through use

of the required reserve ratio.

Comparison of Interbank Market

Interbank

Rate

Main Way of Changing NBR

Discount

Policy

Reserve Requirements

Hong

Kong

HIBOR Convertibility Undertaking/Automatic Pilot

Markup over Fed Funds Rate

None

USA Fed

Funds

Open Market Operation

Set by Fed at level typically above FF rate

Only Checkable Deposits