CHAPTER 17 Tools of Monetary Policy 439 equals nonborrowed reserves (NBR), the amount of reserves that are supplied by the Bank of Canada s open market operations Nonborrowed reserves are set to zero if the demand for reserves is also expected to be zero Initially, the Bank of Canada targeted a daily level of settlement balances of zero, but subsequently the target level of settlement balances varied considerably depending on pressures on the overnight rate; the Bank s target level of balances for a given day is always announced the previous day Assuming here that the Bank is targeting a level of settlement balances of zero, the supply curve for reserves R s is thus the step function depicted in Figure 17-2 Equilibrium in the Market for Reserves Market equilibrium occurs where the quantity of reserves demanded equals the quantity supplied In terms of Figure 17-2, equilibrium occurs at the intersection of the vertical supply curve and the demand curve at the Bank of Canada s target level of reserves More in-depth analysis shows that banks will set the demand for reserves so that the demand curve is expected to intersect the supply curve at the announced target overnight rate of i or* , with the result that deviations from the announced target are fairly small.6 The equilibrium overnight interest rate is necessarily within the operating band For example, when the demand curve shifts to the left to R d1, the overnight interest rate never falls below ib 0.50, while if the demand curve shifts to the right to R d2 , the overnight interest rate never rises above ib Thus the channel/corridor system enables the Bank of Canada to keep the overnight interest rate in between the narrow channel/corridor with an upper limit of ib and a lower limit of ib 0.50 The important point of this analysis is that the channel/corridor approach enables the Bank of Canada to set the overnight policy rate, whatever the demand for reserves, including zero demand THE BAN K O F CAN ADA S APP ROACH TO M ON E TA RY PO L ICY The goal of the Bank of Canada s current monetary policy is to keep the inflation rate within a target range of 1% to 3%, with the midpoint of the inflation target range, 2%, being the most desirable outcome In setting its inflation targets, the Bank of Canada uses the rate of change in the consumer price index (CPI), because it is the most commonly used and understood price measure in Canada Although the Bank s targets are specified in terms of headline CPI (all items), the Bank uses core CPI, which excludes volatile components such as food, energy, and the effect of indirect taxes Core CPI inflation is useful in assessing whether trend inflation is on track for the medium term Also, defining the inflation targets in terms of ranges provides the Bank of Canada sufficient flexibility to deal with supply shocks beyond those already taken care of by the exclusion of volatile components from core inflation Figure 17-3 shows what has happened to the Canadian inflation rate since February 26, 1991, after the Bank s governor and the minister of finance jointly announced a series of declining inflation targets, with a band of plus and minus one percentage point around them In what follows, we examine the tools used by the Bank of Canada to implement monetary policy, leaving a detailed analysis of the Bank s monetary policy for Chapter 18 See Michael Woodford, Monetary Policy in the Information Economy, in Symposium on Economic Policy for the Information Economy (Federal Reserve Bank of Kansas City: 2001), pp 297 370