Monetary Policy, Open Market Operations and Overnight Rate

Monetary Policy, Open Market Operations and Overnight Rate

• In a recession (or recessionary gap), the central bank should use

  expansionary

  ---

  monetary policy which means

  increase

  ---

  the money supply and

  decrease

  ---

  the interest rate so that it is

  cheaper

  ---

  to take loans and spending increases.
• In an economic boom (inflationary gap), the central bank should use

  contractionary

  ---

  monetary policy which means

  decrease

  ---

  the money supply and

  increase

  ---

  the interest rate so it is more expensive to take loans and spending decreases.

Open Market Operations

• Open Market Purchase - this is when the central bank purchases government bonds (Treasuries) from the public. It would cause money supply to

  increase

  ---

  and interest rate to

  decrease

  ---

  . It is normally used in a

  recession (recessionary gap)

  ---

  .
• Open Market Sale - this is when the central bank sells government bonds (Treasuries) to the public. It would cause money supply to

  decrease

  ---

  and interest rate to

  increase

  ---

  . It is normally used in a

  boom (inflationary gap)

  ---

  .

Other Central Bank Tools

• Quantitative easing - a purchase by the central bank of government or non-government securities (like bonds) with long maturity terms. It causes the money supply to

  increase

  ---

• Foreign Exchange Market Operations - the purchase or sale of foreign money by the central bank. Example: If the Canadian central bank buys 100 million Euros in the foreign exchange market in exchange for 130 million Canadian dollars it means the Canadian money supply will

  increase

  ---

  . If the central bank sells Euros in the foreign exchange market it means the Canadian money supply will

  decrease

  ---

  .
• Sterilization - the process of offsetting foreign exchange market operations with open-market operations, so that the effect on the money supply is cancelled out. Example: If the Canadian central bank sells 100 million Euros in the foreign exchange market in exchange for 130 million dollars and does not want the Canadian money supply to decrease, it could conduct an open market

  purchase

  ---

  .
• Reserve Requirements - regulations on the minimum amount of reserves that commercial banks must hold against deposits (not commonly used). Example: In a recession the central bank can

  lower

  ---

  the reserve requirements the commercial banks have to keep so that they can loan out

  more

  ---

  .

Overnight Rate

• Overnight Rate - the interest rate on very short-term loans between commercial banks. In a recession the central bank would

  decrease

  ---

  the overnight rate.
• Bank Rate (Discount Rate) - the interest rate charged by the central bank on loans to the commercial banks (also called discount loans). In a recession the central bank would

  lower

  ---

  the bank rate.
• Deposit Rate - the interest rate the central bank gives commercial banks on their deposits at the central bank.
• Operating Band - this is the gap between the overnight rate, bank rate and deposit rate. In most countries it is around +/- 0.25% Example: If the deposit rate is 0.5%, then the overnight rate is

  0.75%

  ---

  and the bank rate is

  1%

  ---