THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 481

CHAPTER 17

Tools of Monetary Policy

449

3000
2500
2000
1500
1000
500
0
500
1000

F I G U R E 17- 9

9/9/2008

10/9/2008

8/10/2008

7/11/2008

6/11/2008

5/13/2008

4/13/2008

3/13/2008

2/12/2008

1/13/2008

12/14/2007

11/14/2007

9/15/2007

10/15/2007

8/16/2007

7/17/2007

6/17/2007

5/18/2007

1500

Deviations of the Actual Level of Settlement Balances from the Target
Level of Settlement Balances (in millions)

Source: Bank of Canada website, www.bankofcanada.ca.

interest rate the day that they occur, unlike pre-announced changes to the target
level of settlement balances, which appear to have a significant effect on the
overnight interest rate.

AP P LI CATI O N

Monetary Control in the Channel/Corridor System
Suppose that the operating band is 4.5% to 5% and the Bank of Canada expects the
economy to exceed its capacity in the near future. To prevent inflationary pressures
from building, the Bank wishes to tighten monetary policy by raising the target and
operating band by 25 basis points. In one of the eight fixed days for announcing
changes to the target and operating band for the overnight rate, the Bank
announces, at 9:00 a.m., that it is adjusting the target and operating band up from
4.5% to 5% to 4.75% to 5.25%. From this announcement, LVTS participants know
that the bank rate shifts from 5% to 5.25%, the rate on positive settlement balances
shifts from 4.5% to 4.75%, and that the Bank of Canada s new target overnight rate,
the midpoint of the operating band, shifts from 4.75% to 5%.
Later in the day, at 11:45 a.m., if overnight funds are trading below the target
overnight rate (the midpoint of the operating band), the Bank of Canada enters
into SRAs to enforce the new target for the overnight rate. That is, it sells government securities to primary dealers, who pay for the securities with settlement balances and agree to sell the securities back to the Bank of Canada on the next
business day, at a price that works out to an annual interest rate of 5% the midpoint of the new operating band. Assuming that the Bank of Canada enters into
SRAs in the amount of $100, the T-accounts of the Bank of Canada and the primary dealers will be