RDP 9214: The Cash Market in Australia 4. Conclusion

This paper has presented a simple model of the workings of the Australian cash market, illustrating the key features of the same-day/next-day nexus on which the dynamics of the market depend and the impact of changes in cash flows on cash rates.

The model presented here reflects the contemporary structure of the market — in particular, it embodies the Reserve Bank's post-January 1990 approach of announcing changes in monetary policy in the form of new target levels for cash rates. Under this operating regime, cash rates have generally been within quite narrow bands around the announced target rates.

There are, of course, some shortcomings of a simple model like the one presented here. One important one is that the model makes it look too easy to keep cash rates at their target levels. In fact, there have been occasions when cash rates have risen sharply above the announced target levels for short periods. The model presented in this paper suggests that this would occur if there was a very large outflow of ES cash but even then the safety valves — the late repurchase facility for authorised dealers and the rediscount facility — should limit the scope for cash rates to rise.

These safety valves — indeed, the whole of the Reserve Bank's intervention in the market — depend on the ready availability of CGS to sell to the Bank. There are times when friction in the market, associated with the existence of credit and dealing limits between counterparties, makes it difficult to transfer holdings of securities — and hence access to cash — to the parties that need it. Of course, like all frictional effects, these tend to be short-lived and even then the resulting fluctuations in cash rates are of a smaller order of magnitude than occurred under past operating regimes.

Another reason why cash rates might move up sharply stems from each bank's desire to keep its level of ES balances above a minimum “comfort” level. If ES balances fall to this level, the bank will curtail its non-ES lending and begin to borrow non-ES funds in the unofficial market, with the aim of building up its ES levels the next day. If the overall level of ES balances is very low, many banks will be trying to do this simultaneously and, in terms of Figure 1, the supply curve for non-ES funds will move to the left and the demand curve will move to the right — a sizeable increase in the cash rate is likely. Of course, this cannot increase the overall level of ES balances available to banks — at most, it just changes the distribution between banks — but the resulting increase in the cash rate would be enough to induce the Reserve Bank to inject ES so as to return cash rates closer to their announced target level. Initially, this would depress the official cash rate but within a few days would also work through to the unofficial rate by reversing the shift in the demand and supply curves for non-ES funds.