Chapter 20

1. Chapter 20 Monetary Policy Tools

2. Monetary Policy Tools • The central bank has 3 main tools (AKA operating instruments) to conduct monetary policy. • Asset Market Transactions • Open Market Operations • Currency Market Operations • Discount Window Lending • Reserve Requirements • Monetary policy tools are used to manipulate interbank lending market.

3. 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.

4. Interest Rates in Interbank Markets

5. 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.

6. Interbank Market iIB S i* D Clearing Balances

7. 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

8. Open Market Purchase iIB S S´ i* 1 2 i** D Clearing Balances

9. Open Market Sale S´ iIB S i* 2 1 i** D Clearing Balances

10. 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.

11. Demand for Liquidity Rises S iIB 2 i** i* 1 D´ D Clearing Balances

12. Demand for Liquidity Falls iIB S i* 1 i** 2 D´ D Clearing Balances

13. 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.

14. Interbank Market w/ discount window iIB iDW S i* D Clearing Balances

15. Demand for Liquidity Increases Suddenly iIB 2 iDW S BR i* 1 D´ D NBR Clearing Balances

16. Sharp increase in demand for liquidity

17. 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.

18. 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.

19. Interbank Market w/ discount window iIB iDW S iFF D Clearing Balances

20. HIBOR vs. Fed Funds

21. Interbank Market w/ discount window iIB iDW S 2 iFF 1 D Clearing Balances

22. 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.

23. Fed funds rate rises. iIB iDW S iFF D Clearing Balances

24. 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.

25. Expectation of Revaluation iIB iDW S iFF D Clearing Balances

26. 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.

27. 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.

28. Double Play w/ Discount Window iIB iDW S iFF D Clearing Balances

29. HK Interbank Market and Expectations of Revaluation

30. 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.

31. Comparison of Interbank Market