This report will aim to introduce the idea of monetary policy instrument while providing an extensive background on the different instruments which central banks may use for monetary policy. It will outline the advantages and disadvantages of each method before enduring to conclude the main instrument which is currently being used by the RBA in implementing monetary policy. The report also provides a clear summary of the main process outlined by the two given articles in which the RBA achieves its target level for the cash rate.
Explanation of Monetary Policy
Monetary policy is a term given to the decisions about the different levels of interest rate in the economy. Monetary policy instruments are designed to manage short-term rates and changing reserves for commercial banks (Coombes and Reimer, 2009). Monetary policy according to Otto (as stated in Coombes and Reimer, 2009) can be unrestrained and/or limiting for the economy. For example, short-term rates could be low/high relative to inflation rate. The ultimate goal is to achieve economic stability. This includes economic growth, low inflation and low unemployment, achieved by altering; the amount of money in the economy, the cost and accessibility of credit and reducing national debt (Friedman, 2000; Bernanke, Olekalns & Frank, 2008).
Main instruments for Monetary Policy
Central Banks have three main instruments available to it in order to implement monetary policy (Cenbank, 2009):
Open market operations (OMO): this is the main tool used where it is the purchasing or selling of Government bonds from/to the public for the purpose of increase/reducing the balances of banks' ES accounts. In the RBA (2003) bulletin it states that if the Central Bank buys bonds, the result would augment the money supply and decrease interest rates, the converse is also significant if bonds are sold. This is the main instrument used as it has excellent control of the money supply and has a fairly smooth interaction with the economy (Bernanke, Olekalns & Frank, 2008).
Reserve requirements (RR): a percentage of commercial bank's demand deposit liabilities which remains on deposit at the Central Bank. This even though infrequently used has the following affect; if there is an increase in the RR percentage then this would minimise the money supply by entailing a greater percentage of the banks demand deposits to be apprehended by the Central Bank. As Harvey (2008) says in effect, an increase in RR would increase interest rates an outcome which is not useful, as less currency is available to borrowers.
The Discount Window: this instrument as adapted from (Cenbank, 2009) allows for commercial banks to use securities from the Central Bank at a lower discounted rate which is set below short term market rates. This facilitates institutions to change credit conditions like the amount of money they have to loan out. This in effect has major impacts on the money supply as Central Banks have no control over this instrument.
Instrument used by the RBA to implement monetary policy
The Central bank in Australia is the Reserve Bank of Australia (RBA). The RBA makes and implements monetary policy through open - market operations. This instrument of monetary policy is used to closely control short-term interest rate. The relevant interest rate for Australia is the cash rate, which is the market interest rate on overnight funds (RBA, 2003). This allows the Reserve Bank to use OMO to influence the overall level of cash by ensuring that the overnight cash rate is as close as possible to the target rate, through supervising the supply of funds accessible to commercial banks in the money market (Coombes and Reimer, 2009; Friedman 2000) (Refer to Appendix A and the figure on the right). Nevertheless, an announcement by the RBA can and will have the similar impact as OMO, since commercial banks must follow the change in rates or they will often lose since the rates by the RBA and Bank's are not equivalent (Bernanke, Olekalns & Frank, 2008).
Summary of main processes discussed in articles
The RBA can do the following to influence the cash rate:
When there is excess cash in the system causing the cash rate to fall below its target rate the RBA will sell government bonds to banks. As the banks pay cash from their ESA in exchange for the bonds, their ESAs are debited, creating a need for the banks to borrow funds in the overnight cash market. This increase in demand for borrowed funds leads to a rise in the overnight cash rate. In this way, the RBA is able to push up the cash rate, reducing the risk of high inflation. (Coombes and Reimer, 2009; Harvey, 2008; RBA, 2003).
2 - On the other hand, when there is a shortage of cash in the system, RBA will buy back government bonds. As banks receive payments from the RBA, their ESAs are credited. The increased supply of cash effectively lowers the cash rate back towards RBA's target rate (Harvey, 2008; RBA, 2003; Coombes and Reimer, 2009). Open market sales and purchases together are called open market operations, which is used effectively as the most convenient and flexible tool that the reserve bank has for affecting the level of bank reserves and inevitably the cash rate (RBA, 2003).
Friedman (2000) states the cash rate has a strong relationship to market interest rates (Refer to Appendix C and the right figure) and the level of aggregate balances that commercial banks have in their ES accounts at the RBA. For example, when consumers make tax payments to the government, cash is reduced from the economy, and the RBA has to augment the supply of ES funds to sustain the cash rate and hence keep on target (RBA, 2003) (Refer to Appendix B). If OMO did not counteract the resulting streams into and out of ES accounts, banks will see themselves flush with funds one day, but facing a shortage the next (Coombes and Reimer, 2009).
Both articles argue that while OMO are required to maintain the actual cash rate near the target, they are not required to shift the actual cash rate to a new target rate. The anticipation that the RBA will guarantee that the cash rate is at target is sufficient for the rate to alter instantly upon announcement of a new target rate (RBA, 2003). The RBA evidently transfers the cash rate to a new target rate through base money, not by changing the quantity. Base money is classified as the hand to hand currency circulating within the financial system and aggregate balances in ES accounts that commercial banks carry as part of their reserves at the RBA (Coombes and Reimer, 2009).
Conclusion
In conclusion it is therefore clearly evident for the aforementioned that there are many instruments available for central banks to implement monetary policy but in Australia the RBA uses open-market operations in order to achieve this. Both articles conclude that direct control over the conduits of base money not quantity is required to shift the cash rate to a new target. Nevertheless, an announcement, accompanied by a change in the ES rate, is sufficient to control the movement of the cash rate.
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Appendices
Appendix A (Coombes and Reimer, 2009)
The above diagram shows the demand and supply curve of ES accounts as suggested by Coombes and Reimer (2009). If the transaction demand for settlement balances (TB) as shown is shifted, the demand function would shift from DES1 to DES2. To address this banks use the overnight deposit market in which the cash rate becomes under increasing pressure, shifting it away from the targeted cash rate (CT). However, as the RBA (2003) article states the RBA is able to monitor the aggregate level of balances in ES accounts and thus indirectly the cash rate. This is the reason why this figure has a vertical supply for settlement funds (SES). A very nice technique used by the RBA to keep at target rate is when the RBA buys securities and reserves from the banks; it credits the Exchange Settlement Accounts and increases the aggregate supply of settlement funds. This in affect would shift to the right from points a to b, keeping the actual cash rate on target at C1.
Appendix B (Coombes and Reimer, 2009)
The following figures show the effective supply of ES funds on the target rate.
Appendix C
Both figures above show the relationship between cash rate and the relevant interest rate. The inflation rate suggests the different periods of the business cycle which the economy was at and thus showing the strong relationship between market interest rate and the cash rate.
