Bridging the Textbook Gaps on How the RBA Implements Monetary Policy 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 +/-25 bps.

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 supply of cash to put downward or upward pressure on the cash rate.

    – The shift in supply curve is achieved through OMO.

    – 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.

    – Gravitation of market forces to the centre of the band.

    – 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.

OMOs are used to supply cash and keep the cash rate at target

– OMOs are conducted every day through 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.