Question

The current overnight loans rate is 3 percent, with the Bank of Canada's operating band set at 2.75 to 3.25 percent. If the Bank of Canada lowers their operating band to 2.25 to 2.75 percent, which of the following is one of the reasons the overnight rate will fall to within this new range?

Question 44 options:

	A) Since the banking system can now borrow from the Bank of Canada at 2.75 percent, no bank would borrow on the overnight loan market at 3 percent.
	B) Since the banking system can now borrow from the Bank of Canada at 2.25 percent, no bank would borrow on the overnight loan market at 3 percent.
	C) Since the banking system can now earn 2.75 percent from the Bank of Canada, no bank would lend on the overnight loan market at 3 percent.
	D) Since the banking system can now earn 2.25 percent from the Bank of Canada, no bank would lend on the overnight loan market at 3 percent.
	E) There is a legal requirement that the overnight rate must be within the Bank of Canada's operating band.

Answer 1

Ans:- (B)

Explanation:-

The Bank of Canada has a system of an "operating band" for overnight trading.” This band is one-half of a percentage point wide and at the center of the bank is the target for the overnight rate. For example, if the operating band is from 2.25 to 2.75%, the target for the overnight rate is 2.5%. The top of that band, 2.75%, is the bank rate—the interest rate that the bank charges on one-day loans to LVTS participants. The bottom of the band, 2.25%, is the deposit rate—the interest rate that the bank pays on any surplus left on deposit overnight at the bank.

Since LVTS participants know that the Bank of Canada will always lend them money at the top rate of the band and will pay interest on deposits at the bottom rate of the band, there is no reason to trade at rates outside the band. The Bank can also intervene in the overnight market at the target rate if the market rate is moving away from the target. The target for the overnight rate is the favored rate for international comparisons. It is considered comparable with the U.S. Federal Reserve’s target for the Federal funds rate, the Bank of England’s two-week “repo rate” and the minimum bid rate for refinancing operations (the repo rate) of the European Central Bank.