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Monetary Policy Implementation and Payment System Modernization

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Canada plans to adopt a retail payment system to allow Canadians to pay in real time (or near real time) 24 hours a day, 7 days a week. However, the traditional model for setting the overnight interest rate does not operate 24/7.

In this paper, we adapt the traditional model to include paying after hours when participants do not have access to central bank lending and deposit facilities. If they do not have access to the central bank, they cannot send a payment after hours unless they have the funds available. This leads to what is called a “precautionary demand” for more funds to reduce the chance that payments cannot take place. This precautionary demand can cause the overnight interest rate to go up.

This upward pressure depends on two aspects of the framework for implementing monetary policy:

  1. If uncertainty about the flow of after-hours payment is fairly low, allowing payments to be made 24/7 will cause only a small amount of pressure for the overnight interest rate to go up.
  2. If the framework naturally has a large level of settlement balances (deposits at the central bank), the upward pressure will also be minimal. Here are two contrasting examples:
    • Floor systems (where the overnight rate trades near the central bank deposit rate) already have a large level of settlement balances.
    • Corridor systems (where the market rate is set within a certain range, called a corridor) that do not have a required level of settlement balances (that is, there is no reserve requirement) are more likely to experience upward pressure on overnight interest rates with 24/7 settlement compared with rates without 24/7 settlement.