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.

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Answer 1

The Bank of Canada has maintained a stable inflation rate, financial system and an efficient management of government funds and debts with the implementation of “Corridor System”. It helps to control overnight interest rates creating a operating band which controls overnight interest rates. The operating band consist of ceiling and floor interest rates. The ceiling rate is the charge imposed on overnight overdraft loans (i.e Bank Rate) .On the other hand the lower limit is the charge for deposits held overnight. These Bank rate and deposit rate set by Bank of Canada maintain a operating band which controls the interest rates.

The figure below describes how Bank of Canada maintains demand supply scenario for Bank& Deposit rate. From the figure it can be illustrated that if the overnight interest rates fall the supply of settlement balances rises allowing the Bank of Canada to target overnight interest by controlling the bank rate and deposit rate. Therefore Bank of Canada pushes enough excess settlement balances to maintain the corridor system.

One of the drawback associated with the corridor system is attaining near zero settlement balances. It results from the material spread between the actual market rate and bank rate resulting from premium associated with collateral cost and credit risk adjustments