CHAPTER 17 Tools of Monetary Policy 449 3000 2500 2000 1500 1000 500 500 1000 F I G U R E 17- 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