ECON1102 Discussion Question Final

8/6/2019 ECON1102 Discussion Question Final

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(i)

Australia has a floating exchange rate; monetary policy involves the

management of short-term interest rates to achieve domestic policy objectives.

A monetary policy instrument is a tool that is used a monetary authority in acountry (for Australia, this is the Reserve Bank of Australia) to control the supply

of money for the purpose of pursuing its monetary policy objectives such as

maintaining the stability and efficiency of the financial markets.

The Reserve Bank of Australia (RBA) is Australias central bank. It has two main

responsibilities:

Responsible for formulating and implementing monetary policy

Responsible for the oversight and regulation of financial markets.

In this discussion question, we will only be focusing on the former.

Monetary policy decisions involve setting the interest rate on overnight loans in

the money market.

The Reserve Bank of Australia sets the interest rates in accordance of fulfilling

the objectives set out in the Reserve Bank Act 1959

The stability of the currency of Australia

The maintenance of full employment in Australia

The economic prosperity and welfare of the people of Australia.

Some instruments for monetary policy are:

Reserve Requirement The central bank requires a commercial bank to

hold a fraction of their reserves as cash to limit the amount of loans banks

can make and hence reducing the money supply.

Open Market Operations The central bank buy and sells bonds through

the exchange settlement accounts in commercial banks to control the

supply of reserves in a bank. Lending by the Central Bank The central bank may provide credit to

commercial banks to control the supply of reserves.

Interest Rates The central bank provides more credit to commercial

banks with the most ideal interest rate (for the monetary objectives) to

allow more loans to be made by that bank and affect the supply of loans,

affecting quantity of savings and investments.

Exchange rate The central bank buys and sells foreign exchange to

control the exchange rate so that it does not affect the domestic moneysupplies in a negative way.


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The instrument currently used by the Reserve Bank of Australia is the interest

rates. The RBA controls the overnight cash rates through its Open Market

Operations the RBA achieves the optimal target overnight cash rate by buying

and selling bond and securities through their Exchange Settlement Accounts with

the Commercial banks. This affects the commercials banks reserves and hence

affects their supply of money.

Monetary policy is conducted through the use of open-market operations to

secure a target level for the overnight cash interest rate. As other interest rates

in the economy closely follow the overnight cash rate, this gives the Reserve

Bank the ability to influence all of the interest rates in the economy.

(ii)

The way the Reserve Bank of Australia implements the monetary policy is by

controlling the cash rates of overnight loans. The cash rate is decided in a

monthly meeting and maintained through Open Market Operations. Transactions

are made daily through Exchange Settlement Accounts to control the aggregate

balances in these accounts. The aggregate balance is the main supply of money

within banks, by controlling this; the RBA can maintain the overnight cash rate it

sets. The RBA can increase the level of balances to force the cash rate

downwards and vice versa.

The RBA pays interest 0.25% below the cash rate for money in the ExchangeSettlement Account and receives interest 0.25% above the cash rate for money

it lends out, this makes it more desirable to lend and borrow between

commercial banks at the cash rate instead of making transactions with the RBA

(this means the level of aggregate balances does not change), and hence

keeping the cash rate at the desirable level. Open Market Operations are only

used to maintain the cash rate as it is not required to shift to the new target

rates, this is because the cost of holding or and the gain of lending out within the

overnight market does not change, it will still be the margin of 0.25% so the cash

rate automatically shifts to the target as soon as announcements are made.

Throughout the years, different securities have been introduced for open market

operations such as repurchase agreements (repos) of Commonwealth

Government Securities(which were short-dated securities issued by the

government), with the repurchase agreement, the RBA was able to manage

when these securities can be bought back. In recent years, more securities have

been introduced into this system such as domestic securities issued by central

borrowing authorities of State and Territory governments and supranational

organisations. The introduction of these securities means less dependence on

CGS and also allows the implementation of real-time gross settlement (RTGS) for

intraday transactions. This has allowed more activity in the interbank financial

market and required more effort in allocations for repos. Bids and offers are


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made to the RBA each day and longer termed securities are also introduced,

these are non preferred terms for participants as they are less flexible but offers

are still considered.

Another instrument used by the RBA in occasions is the foreign exchange; the

RBA may make foreign exchange swaps as substitution for the Open MarketOperations, this means that the RBA uses Australian currency to buy foreign

exchange, this process was introduced as there is a decrease in the amount of

government securities issued, meaning the money available cannot be used to

buy more domestic securities. This instrument is in the form of a swap in foreign

exchange, usually with a set rate or a point in time in the future where the

foreign exchange is swapped back, this is very similar to the function of a

repurchase agreement. In recent years the RBA has also disclosed more

information on the Open Market Operations in order to keep the participants in

the market better informed and market transparent so that market forces are

the main forces affecting the transactions.

Documents

ECON1102 Discussion Question Final