438 PA R T V Central Banking and the Conduct of Monetary Policy Desired reserves are insurance against deposit outflows, and the cost of holding these reserves is their opportunity cost, the interest rate that could have been earned on lending these reserves out, which is the overnight interest rate Thus, as the overnight interest rate decreases, the opportunity cost of holding desired reserves falls and, holding everything else constant, the quantity of reserves demanded rises Consequently, the demand curve for reserves, R d, slopes downward in Figure 17-2 Supply Curve The Bank of Canada s standing liquidity facilities (lending and deposit facilities) define an effective supply curve for settlement balances, shown in Figure 17-2 In particular, with a standing lending facility, the Bank of Canada does not limit the amount of borrowing by banks, but always stands ready to make collateralized overdraft loans (advances) at the lending rate, ib Thus the quantity of reserves supplied is flat (infinitely elastic) at ib , as shown in Figure 17-2, because if the overnight interest rate, denoted by ior , begins to rise above ib , banks would just keep borrowing from the Bank of Canada indefinitely On the other hand, the Bank of Canada s deposit facility pays banks a fixed interest rate, ib 0.50 on any reserves (deposits) they would like to keep at the Bank of Canada The quantity of reserves supplied is also flat at ib 0.50, because if the overnight rate begins to fall below this rate, banks would not lend in the overnight market Instead, they would keep increasing the amount of their deposits in the Bank of Canada (effectively lending to the Bank of Canada), and would thereby keep lowering the quantity of reserves the Bank of Canada is supplying In between ib 0.50 and ib , banks will not borrow from the Bank of Canada and borrowed reserves (BR) will be zero, because borrowing in the overnight market is cheaper Thus, between ib 0.50 and ib , the quantity of reserves supplied Overnight Interest Rate, i or Rs Bank Rate, i b * i or ib R 2d 0.50 Rd R 1d NBR F I G U R E 17- Quantity of Reserves, R Equilibrium in the Market for Reserves in the Channel/Corridor System for Setting the Overnight Interest Rate In the channel/corridor system, standing liquidity facilities result in a step function supply curve, R s Equilibrium occurs at the intersection of the supply curve R s and the demand curve R d at an interest rate of i*or.Then if the demand curve shifts between R d1 and R d2 , the overnight interest rate ior always remains between ib 0.50 and ib