Bridging the Textbook Gaps on How the RBA Implements a Change to the Cash Rate At a Glance: The Reality of Monetary Policy Implementation

What the textbook says What actually happens
Understanding the implementation of monetary policy

Typical Textbook Analysis – demand/supply curve

– Changes in the cash rate are associated with changes in the quantity of cash in the financial system.

– Central bank increases or decreases the supply of cash.

Inline Equation

Actual Implementation Process

Policy interest rate corridor is key.

– RBA offers standing facilities which pay/charge banks the cash rate +0.25/-0.10 percentage points.

Inline Equation

– Corridor:

  • A ceiling and floor boundary for the supply/demand curve.
  • Represents a range within which banks have an incentive to trade ES balances amongst themselves.
Cash rate change

Typical Textbook Analysis

Inline Equation

Actual Implementation Process

Inline Equation

  1. Central bank changes the quantity of system cash to change the cash rate.

    – Injects or withdraws cash to put downwards or upwards pressure on the cash rate.

    – The shift in the supply curve is achieved through OMOs.

    – If central bank buys bonds (and gives cash), it increases the supply of cash.

    – If central bank sells bonds (and receives cash), it reduces the supply of cash.

    – This requires additional buying or selling of bonds through OMOs.

  1. Quantity of cash does not change.

    – After a policy rate decision, the interest rate corridor is reset around the new target rate.

    – The market will simply move to the new rate without the RBA having to change the supply of ES funds.

    – No incentives to borrow or lend outside the corridor.

    Prior to the COVID-19 recession:

    – The market had a tendency to simply move to the new rate without the RBA having to change the supply of ES funds.

    – Market convention that banks automatically trade at the new target cash rate following a policy change.

  1. Central bank conducts OMOs to implement a change in the cash rate.

    – After a change in the cash rate the central bank conducts OMOs to change the amount of system liquidity and influences the market to trade at the new target cash rate.

    – The amount of liquidity supplied is determined by the policy rate decision.

  1. Additional OMOs are not necessary for a change in the cash rate.
OMOs are used to change the cash rate, including after a policy rate change.

Prior to the COVID-19 recession, OMOs were used to supply cash and keep the cash rate at target

– OMOs were conducted daily through an auction.

– Three types of transactions: outright purchases; repos and reverse repos; foreign exchange swaps.

– Reverse repos are the most common tool.

– On most days, the RBA injects cash into the market by buying bonds under reverse repo.

– The total amount of system liquidity is only changed by payments going to and from the government (such as tax and social welfare payments).

– The RBA gauges how these transactions will change the supply of ES funds in the banking system each day and uses OMOs to smooth the liquidity effects.

Since the onset of the recession, OMOs have been used to complement the RBA’s other monetary policy tools.

– The increase in ES funds due to the introduction of unconventional monetary policy tools has resulted in the cash rate trading below the target cash rate.