Question

Fully explain the channel/corridor system used by the Bank of Canada in achieving target policy rates in the overnight market. Be sure to include a discussion of reserve demand and supply, how the BOC achieves the policy rate within system, and any potential issue that may prevent the channel/corridor system from achieving monetary policy objectives.

Answer 1

The Bank of Canada is the central bank of Canada. it plays an important role to boost the welfare of the economy. Managing the monetary policy of the country is one of the fundamental responsibilities of the bank. The goal of monetary policy is to contribute to solid economic performance and rising living standards for Canadians by keeping inflation low, stable, and predictable. The BoC implements monetary policy by raising or lowering the target for the overnight rate, which is the interest rate at which major financial institutions borrow and lend one-day (or overnight) funds among themselves.

The change in overnight rate, changes rates in other market rates and thus changes the demand of credit and demand for money.

Inflation targets in developed economies are are ranged at around 1% to 3% per year. Targeting an inflation rate that is too low or too high might create some problems. An inflation target that is too low can lead to higher unemployment, this can also restrict the central bank’s ability to support the recovery of the economy in times of recession, and also it will increase the chances or frequency of deflation rather than inflation. Of course, no one wants to have an inflation target that is too high either, as inflation costs can be considerable.

In the early time of 1992, the BoC had targeted a range inflation of 3–5 per-cent. This fell to 2–4 percent by 1993 and to 1–3 percent by the end of 1995. When the 2% goal was reached, it was judged to successfully deliver good overall economic performance. The BoC has examined the 2% target carefully over the years and considers the case for both a lower and a higher inflation target.

The Bank of Canada fixes its overnight rates as much as eight times each year. In order to increase inflation BoC reduces overnight rates. This allows banks and lenders to lower their mortgage rates, car/personal loan rates, and credit card rates, which encourages companies and individuals to borrow money. The theory behind this is the fact that once the citizens see that it costs less to borrow, they will spend more. This usually increases demand for products and services, and boosts the economy as well as inflation. On the flip side, if the BoC needs to decrease inflation, it raises its overnight rates. This way, people will be more cautious about borrowing, and it also helps cool hot markets – including the housing market. One growing concern is that Canadians have an increasing amount of personal debt load, and organizations like the Bank of Canada want to avoid the potentially catastrophic impact it will have on the country if interest rates rise drastically. When people are saddled with debt, the economy can come crashing to a halt.

Each time the overnight rate changes, banks and lenders follow suit and change their lending rates accordingly. Although many people believe that the Bank of Canada’s rate is the sole determining factor for whatever rate the banks use, this is not always the case. Banks and lenders also look at additional factors such as the various financial markets, political situations worldwide, trade policies, as well as the strength of the borrower’s application and credit history. The Bank of Canada does not set the rates for lenders, it just guides them; that is one reason why you’ll see a difference in rates between the various banks and lenders.