CHAPTER 17 Tools of Monetary Policy 447 and ultimately reducing settlement balances by an amount equal to the government s net receipts In the absence of any offsetting transactions by the Bank of Canada, through the workings of supply and demand, a decline in settlement balances will normally cause an increase in the overnight interest rate, as many LVTS participants would have to borrow more to meet their settlement obligations However, in targeting the overnight interest rate, the Bank of Canada will neutralize the net government receipt by arranging a net increase of $100 in the government deposit auctions to leave the system unchanged This procedure results in the following balance sheets for the Bank and the LVTS participants: Bank of Canada Assets LVTS Participants Liabilities Government deposits Settlement balances *100 Assets Liabilities Settlement balances +100 Government deposits +100 +100 Note that government deposits at the Bank of Canada are reduced by $100 and at the same time the settlement balances of the LVTS participants are increased by $100 If instead of a net receipt by the government, there was a net disbursement of $100 (i.e., the government s payments to the public exceed its receipts from the public by $100), then the financial system s settlement balances would increase by the same amount This would prompt a fall in the overnight interest rate, as many LVTS participants would have to borrow less to meet their settlement obligations The Bank s neutralization process would prevent a decline in the overnight rate by reducing the banking system s settlement balances This would involve LVTS transfers of $100 (i.e., the difference between the total amount of government balances maturing and the total amount of government balances auctioned) from the government s accounts at the participating institutions to the government s account at the Bank This procedure results in the following T-accounts: Bank of Canada Assets LVTS Participants Liabilities Government deposits Settlement balances Assets +100 Settlement balances Liabilities *100 Government deposits *100 *100 In this case government deposits at the Bank of Canada are increased by $100 and at the same time the clearing balances of the participants are reduced by $100 Swaps with the Exchange Fund Account When the Bank of Canada transfers government balances, it usually brings onto its balance sheet Exchange Fund Account assets to back its liabilities It does so by arranging a swap with the Exchange Fund Account, which holds the country s foreign exchange reserves This involves a spot purchase and a simultaneous forward