THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 469

CHAPTER 17

Tools of Monetary Policy

437

of Canada, the deficit will be financed by a collateralized advance at the bank rate.
Participants with positive settlement balances at the end of the day are paid interest at the bank rate less 50 basis points (i.e., the bottom of the operating band).
Hence, as long as the bank rate is set so that the market bid-ask spread is within
the operating band, participants will resolve their nonzero settlement balances
among themselves rather than through the Bank of Canada s standing facilities. In
fact, in a fully competitive market, participants would be expected to trade at the
midpoint of the operating band for the overnight interest rate.
Clearly, the LVTS and the Bank of Canada s standing liquidity facilities have
been set up in such a way so as to ensure a determinate demand for settlement
balances, treating the costs of deficits and surpluses symmetrically. That is, the cost
of holding excess settlement balances (an opportunity cost of 25 basis points)
equals the cost of holding deficit levels of settlement balances (a premium of 25
basis points for an overdraft loan). These cost incentives are very important in the
absence of reserve requirements; they encourage banks to target zero settlement
balances at the Bank of Canada and in doing so to deal directly with the market
rather than to rely on the Bank s automatic standing liquidity facilities.

The Bank of
Canada s
Implementation
of the
Operating
Band for the
Overnight
Interest Rate

It is through its lending and taking deposits from LVTS participants that the Bank
of Canada implements its target band for the overnight interest rate. If the
overnight rate increases towards the upper limit of the operating band,
then the Bank will lend at the bank rate to put a ceiling on the overnight
rate. The bank rate is the ceiling on the overnight rate in the money market for
LVTS participants, because they are unlikely to borrow overnight funds at a higher
interest rate, since they can borrow at the bank rate from the Bank of Canada.
If the overnight rate declines towards the lower limit of the operating
band, then the Bank will accept deposits from LVTS participants at the
bank rate less 50 basis points, to put a floor on the overnight rate. The bank
rate less 50 basis points is the floor on the overnight rate because LVTS participants are unlikely to lend overnight funds at a lower rate, since they can leave
funds on deposit at this rate at the Bank of Canada.

THE MAR KET FO R SE TTL E ME NT BALA NCE S AN D T HE
CHAN NE L/ CO RRI DO R SYST E M FO R SETT I NG TH E
OVE RN IG HT IN T ERE ST RAT E
The market for settlement balances (reserves) is where the overnight interest rate
is determined, and this is why we turn to a supply and demand analysis of this
market to analyze how the tools of monetary policy affect the overnight rate. Our
analysis of the market for reserves proceeds in a similar fashion to the analysis of
the bond market we conducted in Chapter 4 and describes determination of the
overnight interest rate in a channel/corridor system of interest-rate control such as
that in Canada, Australia, New Zealand, and the euro area.
We derive a demand and supply curve for reserves. Then the market equilibrium
in which the quantity of reserves demanded equals the quantity of reserves supplied
determines the overnight rate, the interest rate charged on the loans of these reserves.

Demand Curve

To derive the demand curve for reserves, we need to ask what happens to the
quantity of reserves demanded, holding everything else constant, as the overnight
interest rate, ior , changes. Recall that banks in Canada are no longer required to
hold reserves. Banks, however, hold some reserves in order to manage their own
short-term liquidity requirements. We called these reserves desired reserves.