Tim Berry, Humber College
Money, Banking, and Financial
Markets:
The Central Bank Balance
Sheet and the Tools of
Monetary Policy
©2010 McGraw-Hill Ryerson Ltd.

17-2
The Central Bank Balance Sheet and
Monetary Policy: The Big Questions
1. How does the central bank interact with the financial system?
2. What is the structure of the central bank’s balance sheet?
3. How is the central bank balance sheet connected to monetary policy?
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The Central Bank’s Balance Sheet
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17-5
The Central Bank’s Balance Sheet:
Assets
• Securities
– B.O.C. usually holds only Gov. of Canada securities
– controlled through purchases and sales known as “open market operations”
• Foreign Exchange Reserves
– bonds issued by foreign governments
• Loans
– Discount loans
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17-7
• Comparing the Fed with the Bank of Canada:
– Both hold majority of their assets in form of securities
– Both are similar on the liability side with most being notes outstanding
• People’s Bank of China:
– Balance sheet has very different structure from
B.O.C. and Fed
– Very high foreign exchange reserves
– High level of loans in form of bonds
©2010 McGraw-Hill Ryerson Ltd.

17-6
The Central Bank’s Balance Sheet:
Liabilities
•
•
•
• Deposits of financial institutions
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17-8 ©2010 McGraw-Hill Ryerson Ltd.

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Importance of Disclosure
• Central banks have to publish their balance sheets.
• Most central banks publish it weekly.
• Misrepresentation is a sign of impending disaster.
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17-10
Monetary Base
• Equals currency plus reserves
• Also known as high-powered money
• Money and credit in the economy is based on this.
• We’ll see how in a moment.
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17-11
The Size of the Central Bank’s
Balance Sheet
• The central bank controls the size of its balance sheet.
• When it buys a security, it can create reserves to pay for them .
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The Central Bank’s Balance Sheet:
Changing the Size & Composition
17-12
1.
Open Market Operations
Buying or selling a security initiated by the central bank
2.
Loans to a Financial Institution
B.O.C. doesn’t force banks to borrow money – they ask for loans
3.
Shifting Govt. Deposits
Moving Govt. of Canada balances from Govt. acct at
B.O.C. to Govt. accts. In the financial system
4.
Cash Withdrawal
Initiated by the nonbank public
©2010 McGraw-Hill Ryerson Ltd.

17-14
The Central Bank’s Balance Sheet:
Open Market Operations
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The Central Bank’s Balance Sheet
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The Central Bank’s Balance Sheet
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The Central Bank’s Balance Sheet:
Cash Deposit
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The Central Bank’s Balance Sheet:
Summary
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17-19
• Immediately following the September 11 attacks one large bank could not make payments, it could only receive them.
• Other banks started to have problems obtaining reserves to make payments
• To make sure the financial system continued to function, the Fed increased reserves by nearly
$150 billion for a few days
©2010 McGraw-Hill Ryerson Ltd.

17-20
Operation of Monetary Policy
The Bank of Canada’s Operational Framework:
• B.O.C. sets overnight target interest rate
• This is the rate at which financial institutions lend to each other – very short-term
• The Bank rate is rate at which the B.O.C. lends to eligible financial institutions
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17-21
Operation of Monetary Policy
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Operation of Monetary Policy
17-22
The Federal Reserve’s Operational Framework:
• Main tool is the target federal funds rate
• Fed funds rate is the equivalent of the B.O.C. overnight rate – except they are uncollateralized
• Primary discount rate is rate at which Fed lends to financial institutions approved by Fed
• Similar to B.O.C. Bank rate
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17-23
Operation of Monetary Policy
The Federal Reserve’s Operational Framework:
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Operation of Monetary Policy
17-24
The European Central Bank’s Operational Framework:
• ECB’s main tool is the overnight interbank rate
• This is the rate at which ECB lends to commercial banks
• ECB provides reserves to European banking system through refinancing operations
• ECB works through national central banks by providing reserves to banks in exchange for securities
• System designed to give ECB control over short- term interest rates in the euro region
©2010 McGraw-Hill Ryerson Ltd.

Operation of Monetary Policy
The European Central Bank’s Operational Framework:
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Linking Tools to Objectives:
Making Choices
Desirable Features of a Policy Instrument:
• A good monetary policy instrument has three features:
• 1. It is easily observable by everyone.
• 2. It is controllable and quickly changed.
• 3. It is tightly linked to the policymakers’ objectives.
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17-27
Linking Tools to Objectives:
Making Choices
Operating Instruments and Intermediate
Targets:
• Operating instruments refer to actual tools of policy.
• These are instruments that the central bank controls directly.
• Every central bank can control the size of its balance sheet.
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17-28
Linking Tools to Objectives:
Making Choices
Operating Instruments and Intermediate Targets:
• Intermediate targets to refer to instruments that are not directly under central bank control but lie instead somewhere between their policymaking tools and their objectives
• The monetary aggregates are a prime example of intermediate targets
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17-29
Linking Tools to Objectives:
Making Choices
Operating Instruments and Intermediate Targets:
©2010 McGraw-Hill Ryerson Ltd.

Tim Berry, Humber College
Money, Banking, and Financial
Markets :
The Central Bank Balance Sheet and the Tools of Monetary Policy
End of Chapter
©2010 McGraw-Hill Ryerson Ltd.