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 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