THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 463

CHAPTER 17

Tools of Monetary Policy

LE A RNI NG OB JE CTI VE S
After studying this chapter you should be able to
1. characterize the framework for the implementation of monetary policy in
Canada (the LVTS, the target and the operating band for the overnight interest
rate, and the Bank of Canada s standing liquidity facilities)
2. explain the market for reserves and the channel/corridor system for setting the
overnight interest rate in Canada
3. identify the Bank of Canada s approach to monetary policy and the tools of
policy (open market operations, settlement balances management, and Bank
of Canada lending)

PRE VI EW

In the chapters describing the structure of the Bank of Canada and the money supply process, we mentioned three policy tools that the Bank can use to manipulate
interest rates and the money supply: open market operations, settlement balances
management, and Bank of Canada advances. Because the Bank s use of these tools
has such an important impact on interest rates and economic activity, it is important to understand how the Bank wields them in practice and how relatively useful each tool is.
In recent years, the Bank of Canada has increased its focus on the overnight
rate, the interest rate on overnight loans of reserves from one bank to another, as
the primary instrument of monetary policy. Since December 2000, the Bank of
Canada has announced an overnight rate target eight times throughout the year,
an announcement that is watched closely by market participants because it affects
interest rates throughout the economy. Thus to fully understand how the Bank s
tools are used in the conduct of monetary policy, we must understand their direct
effects on the overnight interest rate.
This chapter begins with the institutional framework within which the Bank of
Canada conducts monetary policy, followed by a supply and demand analysis of

the market for reserves, where the overnight interest rate is determined.
We then go on to look in more detail at the tools of monetary policy open
market operations, settlement balances management, and Bank of Canada lending to see how they are used in practice.

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