5.4.2 Implementing Monetary Policy

Detailed guide on how the Bank of Canada implements monetary policy using various tools such as the target overnight rate, open market operations, and drawdowns and redeposits.

Overview

Monetary policy in Canada is primarily implemented by the Bank of Canada, which uses various tools to influence interest rates and the money supply. These tools include the target overnight rate, open market operations, and drawdowns and redeposits.

Target Overnight Rate

The Bank conducts monetary policy mainly through changes to the target for the overnight rate, its most important monetary policy tool. This rate is pivotal as it signals policy shifts towards easing or tightening monetary conditions to meet inflation-control targets.

Understanding the Overnight Rate

The overnight rate is set in the overnight market, where major Canadian financial institutions lend each other money in the form of one-day loans (overnight loans). Changes in this rate influence other short-term interest rates, affecting consumer loans and mortgages.

Operating Band

The overnight rate operates within a 50 basis point-wide operating band. A basis point equals 1/100th of a percentage point. The Bank targets the midpoint of this band as its key monetary policy objective. For example, in a 1.5% to 2.0% band, the target rate is 1.75%.

Figure: The Bank of Canada’s Operating Band

    timeline
	   title The Bank of Canada's Operating Band
	   section Upper Limit
	      2.0%: 0
	   section Target Range
	      1.75%: 0
	   section Lower Limit
	      1.5%: 0

Example

When the Bank lowers the target rate from 1.0% to 0.75%, it aims to ease monetary conditions, making money cheaper to borrow and encouraging spending. Conversely, raising the target rate tightens monetary conditions, discouraging borrowing and increasing savings.

Open Market Operations

Open market operations consist of Special Purchase and Resale Agreements (SPRA) and Sale and Repurchase Agreements (SRA). These operations help the Bank control the overnight market within the operating band.

Special Purchase and Resale Agreements (SPRA)

SPRAs, or overnight repos, are used to push interest rates down if they are trending above the target rate. The Bank lends money at a lower rate to increase the money supply and reduce the overnight rate.

Example

If the upper limit of the operating band is 2.0%, and overnight money trades at 2.10%, the Bank can lend at 2.0% to keep the overnight rate within the band.

Sale and Repurchase Agreements (SRA)

SRAs, or overnight reverse repos, increase the interest rate if it falls below the target. The Bank borrows money by selling treasury bills to reduce the money supply, which causes the overnight rate to rise.

Large Value Transfer System (LVTS)

The LVTS is an electronic wire system established by the Bank in 1991 to facilitate large transactions between financial institutions. It helps ensure that trading in the overnight market remains within the Bank’s operating target.

Drawdowns and Redeposits

The federal government maintains accounts with the Bank and the chartered banks. The Bank transfers funds between these accounts to influence short-term interest rates.

Drawdowns

A drawdown transfers deposits to the Bank from the chartered banks, reducing the supply of available cash and causing interest rates to increase. This discourages borrowing.

Redeposits

A redeposit transfers funds from the Bank to the chartered banks, increasing the money supply and reducing interest rates, encouraging borrowing.

Key Takeaways

  • The Bank of Canada uses the target overnight rate, open market operations, and drawdowns and redeposits to implement monetary policy.
  • The target overnight rate signals policy shifts to meet inflation-control targets and influences other short-term interest rates.
  • Open market operations like SPRAs and SRAs help keep the overnight market within the operating band.
  • The LVTS ensures efficient transactions and balance clearance among financial institutions.
  • Drawdowns and redeposits influence short-term interest rates by managing the money supply.

FAQs

What is the target overnight rate?

The target overnight rate is the interest rate set by the Bank of Canada in the overnight market, where major financial institutions lend each other money for one-day loans.

What is a basis point?

A basis point is 1/100th of a percentage point. For example, 50 basis points are equal to 0.5%.

How does the Large Value Transfer System (LVTS) work?

The LVTS allows financial institutions to conduct large transactions through an electronic wire system, ensuring trading in the overnight market stays within the Bank’s operating target.

What is the difference between a drawdown and a redeposit?

A drawdown transfers deposits from the chartered banks to the Bank, reducing the money supply and increasing interest rates. A redeposit transfers funds from the Bank to the chartered banks, increasing the money supply and reducing interest rates.

Glossary

  • Overnight Rate: The interest rate for one-day loans between major financial institutions.
  • Basis Point: A unit of measure equal to 1/100th of a percentage point.
  • SPRA (Special Purchase and Resale Agreement): A tool to push interest rates down by increasing the money supply.
  • SRA (Sale and Repurchase Agreement): A tool to increase interest rates by reducing the money supply.
  • LVTS (Large Value Transfer System): An electronic system for large transaction settlements among financial institutions.

📚✨ Quiz Time! ✨📚

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## What is the primary tool that the Bank of Canada uses to conduct monetary policy? - [ ] Open market operations - [ ] Drawdowns and redeposits - [x] Target overnight rate - [ ] Fiscal policy > **Explanation:** The Bank of Canada conducts monetary policy primarily through changes in the target overnight rate, which signals shifts towards easing or tightening monetary conditions to meet inflation targets. ## How wide is the operating band for the overnight rate set by the Bank of Canada? - [ ] 10 basis points - [ ] 25 basis points - [ ] 75 basis points - [x] 50 basis points > **Explanation:** The operating band for the overnight rate is 50 basis points wide. This means if the band is from 1.5% to 2.0%, the target overnight rate is 1.75%. ## If the Bank of Canada lowers the target overnight rate, what is its intended economic effect? - [ ] To increase interest rates and reduce spending - [ ] To stabilize the currency exchange rate - [ ] To reduce inflation - [x] To ease monetary conditions and encourage borrowing and spending > **Explanation:** Lowering the target overnight rate aims to make borrowing cheaper, thereby encouraging consumers and businesses to borrow and spend more, boosting economic activity. ## How does a Special Purchase and Resale Agreement (SPRA) function in the context of the Bank of Canada’s monetary policy? - [x] It is used to push interest rates down - [ ] It is used to increase interest rates - [ ] It stabilizes the long-term interest rate - [ ] It reduces the money supply in the economy > **Explanation:** An SPRA is used to push interest rates down. The Bank purchases Treasury bills from financial institutions on an overnight basis, increasing the money supply and causing the overnight rate to fall. ## What happens when the Bank of Canada enters into a Sale and Repurchase Agreement (SRA)? - [ ] The Bank lends money to financial institutions - [x] The Bank borrows money by selling Treasury bills, aiming to increase interest rates - [ ] The Bank reduces the operating band width - [ ] The Bank targets long-term interest rates to stabilize the economy > **Explanation:** An SRA involves the Bank borrowing money by selling Treasury bills to financial institutions, thereby reducing the money supply and causing the overnight rate to rise. ## What would be the likely impact on interest rates if the Bank of Canada transfers funds from the government’s account at the Bank to its account at chartered banks? - [ ] Interest rates would increase - [x] Interest rates would decrease - [ ] There would be no impact on interest rates - [ ] The long-term interest rates would stabilize > **Explanation:** Redepositing funds from the government's account at the Bank to the chartered banks increases the money supply, causing interest rates to decrease. ## What is the Large Value Transfer System (LVTS) used for in Canada's financial system? - [ ] To control long-term interest rates - [x] To facilitate large transactions and maintain overnight market interest rates within the operating band - [ ] To manage government fiscal policy - [ ] To automate small daily transactions > **Explanation:** The LVTS facilitates large financial transactions between major institutions, helping to ensure overnight market rates stay within the Bank's target operating band. ## What type of monetary policy is the Bank of Canada implementing if it decides to set the target overnight rate lower? - [x] Easing monetary policy - [ ] Tightening monetary policy - [ ] Neutral policy - [ ] Volatile policy > **Explanation:** Lowering the target overnight rate implies easing monetary policy, which makes borrowing cheaper and aims to stimulate economic activity. ## How frequently does the Bank of Canada announce changes to the target overnight rate? - [ ] Once a month - [ ] Quarterly - [ ] Annually - [x] Eight pre-set fixed dates during the year > **Explanation:** The Bank of Canada announces changes to the target overnight rate on eight pre-set fixed dates throughout the year. ## What is the impact on the banking system when a drawdown is performed by the Bank of Canada? - [ ] It increases the money supply - [x] It drains the supply of available cash balances, causing interest rates to rise - [ ] It decreases interest rates - [ ] It stabilizes interest rates > **Explanation:** A drawdown transfers deposits from chartered banks to the Bank of Canada, reducing the money supply and causing interest rates to increase.

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