How the Reserve Bank Implements Monetary Policy | Explainer | Education (2024)

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The Reserve Bank of Australia implements monetary policy using a variety of tools.The primary tool of monetary policy is the cash rate target, while other tools have,at times, included forward guidance, price and quantity targets for government bondpurchases, and the provision of low-cost long-term funding to financialinstitutions. This Explainer describes how each tool is implemented.

1. Cash Rate Target

How the cash rate target is implemented can be explainedby stepping through five aspects of the cash market: theprice, quantity, demand, supply and the policy interest rate corridor.

How the Reserve Bank Implements Monetary Policy | Explainer | Education (1)

1.1 Price

The cash market is where banks lend and borrow funds from eachother overnight. The price in this market is theinterest rate on these loans. In Australia, thisinterest rate is called the cash rate. As the Reserve Banksets a target for the cash rate, it is often referred to as a‘tool’ of monetary policy.Prior to the COVID-19 recession, the cash rate target was the Reserve Bank's onlyactive monetary policy tool.

1.2 Quantity

The quantity traded in this market is called ExchangeSettlement (ES) balances, which are used to settle interbanktransactions. Banks have deposit accounts at the ReserveBank to record the value of their ES balances. Because theReserve Bank is Australia's central bank and controls banknotesavailable to the public, ES balances are considered to be the equivalent of cash.

1.3 Demand

Banks use ES balances as a store of value and tomake payments between each other. Some ofthese payments are on behalf of their customersand some are related to their own business.Demand may vary for a number of reasons,including changing financial market conditions.

1.4 Supply

Prior to the COVID-19 recession, the Reserve Bankmanaged the supply of ES balances so that it metestimated demand and the cash rate was as closeas possible to its target. This was mainly achievedwith open market operations to manage factorsthat can change the supply of ES balances.

In particular, the Reserve Bank typically managedthe supply of ES balances through repurchaseagreements (repos). A repo is a transaction withtwo parts.In the first part, the Reserve Bank could lend ES balances to a bank and receive abond in exchange (seeExplainer: Bonds and the Yield Curve).This increases the supply of ES balancesavailable to banks. In the pre-arranged secondpart, the transaction is reversed. The ReserveBank returns the bond and receives back the ESbalances. As a result, the supply of ES balancesdecreases. This could help to manage changesin the supply of ES balances arising from otherfactors. For example, any payments made bythe Australian Government or received into itsaccounts at the Reserve Bank will affect the supplyof ES balances.

The package of policy measures introduced by theBoard in response to the COVID-19 recession ledto a substantial increase in ES balances. As a result,the Reserve Bank no longer conducts daily openmarket operations to manage ES balances. Thecash rate is maintained consistent with the targetthrough the interest rate corridor.

1.5 Policy interest rate corridor

The Reserve Bank currently pays an interest rateon ES balances that is 0.1 percentage points belowthe cash rate target. Banks have an incentive todeposit as little as possible at this rate, and insteadprefer to earn the higher cash rate by lending outtheir balances.

The Reserve Bank is also willing to lend ES balancesto banks if this is required. The interest rate onthese loans is 0.25 percentage points above thecash rate target. Banks have an incentive to borrowas little as possible at this rate, and instead prefer toborrow at the lower cash rate in the market.

The deposit and lending rates form the lower andupper bounds of the policy interest rate corridor.Banks have no incentive to borrow or lend ESbalances outside this corridor. If interest rates inthe market were lower than the deposit rate paidby the Reserve Bank, banks would choose tohold more ES balances. Similarly, if market interestrates for cash balances were above the top of thecorridor, banks would choose to borrow morecheaply from the Reserve Bank. The corridorrepresents a range within which banks have anincentive to trade ES balances among themselves.

The corridor also provides a mechanism forimplementing changes to the cash rate target.The bounds of the corridor are set with referenceto the target, so the corridor shifts in line withchanges in the cash rate target, as do theincentives for trading within that range.

In response to the COVID-19 recession, the ReserveBank began actively using other ‘unconventional’monetary policy tools, such as its ‘Term FundingFacility’ and bond purchase program, whichincreased the supply of ES balances (that is, theyshifted the supply curve in the cash market tothe right). This caused the cash rate to drift belowtarget. While the Reserve Bank still operates acorridor system, the increase in supply meansthat the cash rate can trade near the floor of thecorridor, rather than at the cash rate target.

How the Reserve Bank Implements Monetary Policy | Explainer | Education (2)

2. Unconventional Monetary Policy Tools

Since the COVID-19 recession, the Reserve Bank has actively used a number of othermonetary policy tools.

Forward guidance

Forward guidance refers to public commitments made by the RBA as to how it willconduct monetary policy in the future. The RBA's forward guidance takes the form ofdescribing the economic conditions the Board would look to see before it wouldconsider raising the cash rate target. The guidance is based on the state of the economy –that is, it is ‘state-based’. For example, in mid March 2020, the Board communicatedthat it would not increase the cash rate target until progress was made towards fullemployment and it was confident that inflation would be sustainably within the 2-3per cent target band. Reflecting community interest in the Bank's views about howlong it will be before the economy will reach these conditions, the Board alsoprovided a possible timeframe for when these conditions might be met. Given itsforecasts at the time, the Bank initially expected this would take at least threeyears.

Price and quantity targets for asset purchases

In 2020, the Reserve Bank introduced explicit price and quantity targets for itspurchases of government bonds. These programs were designed to reduce longer-terminterest rates, lower funding costs and boost liquidity in the economy during theCOVID-19 recession. The Reserve Bank purchased government bonds to: support a targetfor the interest rate on three-year bonds (the yield target); lower the yield onbonds with a term of longer than three years below where they would otherwise be;and support the smooth functioning of the bond market.

The Reserve Bank purchased government bonds issued by the federal and stategovernments in exchange for ES balances. Importantly, the Reserve Bank purchasedbonds from the private sector in the secondary market, and not from governmentsdirectly.

Term Funding Facility

Also in 2020, the Reserve Bank established a ‘Term Funding Facility’ (TFF) in orderto lower funding costs across the economy. The TFF provided low-cost, fixed termfunding to banks and other financial institutions such as credit unions and buildingsocieties. The TFF worked by offering banks access to three-year loans with theinterest rate fixed at the cash rate target. Because this interest rate was lowerthan banks were usually able to access, banks' funding costs declined and banks wereable to offer lower interest rates on loans to households and businesses. The TFFlaunched in April 2020 and remained open for new borrowing until June 2021. Allloans made under the TFF will mature by June 2024.

To learn more about unconventional monetary policy, see theExplainer: Unconventional Monetary Policy.

3. Future System of Monetary Policy Implementation

In March 2024, the Reserve Bank Board endorsed a plan to move to a new system ofimplementing monetary policy. It will use a system called ‘ample reserves’. Furtherdetails will be provided in due course.[1]

Endnotes

For more information, see Assistant Governor Christopher Kent’s speech The Future System for Monetary Policy Implementation. [1]

How the Reserve Bank Implements Monetary Policy | Explainer | Education (2024)

FAQs

How the Reserve Bank Implements Monetary Policy | Explainer | Education? ›

The primary tool of monetary policy is the cash rate

cash rate
The cash rate is the interest rate that banks pay to borrow funds from other banks in the money market overnight.
https://www.rba.gov.au › cash-rate-target-overview
target, while other tools have, at times, included forward guidance, price and quantity targets for government bond purchases, and the provision of low-cost long-term funding to financial institutions.

How does the Reserve Bank use monetary policy? ›

The Reserve Bank Board sets monetary policy such that inflation is expected to return to the midpoint of the target. The appropriate timeframe for this depends on economic circ*mstances and should, where necessary, balance the price stability and full employment objectives of monetary policy.

How does the Federal Reserve implement monetary policy? ›

The Federal Reserve conducts the nation's monetary policy by managing the level of short-term interest rates and influencing the availability and cost of credit in the economy. Monetary policy directly affects interest rates; it indirectly affects stock prices, wealth, and currency exchange rates.

How do banks implement monetary policy? ›

Central banks conduct monetary policy by adjusting the supply of money, usually through buying or selling securities in the open market. Open market operations affect short-term interest rates, which in turn influence longer-term rates and economic activity.

What are the three tools the Reserve has to implement monetary policy? ›

The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements.

How is reserve requirement used in monetary policy? ›

Reserve Requirements as a Monetary Instrument

An increase in requirements forces banks to purchase temporary liquidity from the central bank, raising their costs, and reduces their lending activity, lowering the public's deposits. Conversely, a reduction allows an expansion in deposits for any given monetary base.

What are reserves in monetary policy? ›

A monetary reserve is the holdings of currencies, precious metals, and other highly liquid assets used to redeem national currencies and bank deposits and to meet current and near-term financial obligations by a country's central bank, government treasury, or other monetary authority.

What methods does the Fed use to enact monetary policy? ›

The Fed uses three primary tools in managing the money supply and pursuing stable economic growth. The tools are (1) reserve requirements, (2) the discount rate, and (3) open market operations. Each of these impacts the money supply in different ways and can be used to contract or expand the economy.

What tools are used for implementing monetary policy? ›

The Federal Reserve has a variety of policy tools that it uses in order to implement monetary policy.
  • Open Market Operations.
  • Discount Window.
  • Reserve Requirements.
  • Interest on Reserve Balances.
  • Overnight Reverse Repurchase Agreement Facility.
  • Term Deposit Facility.
  • Central Bank Liquidity Swaps.

Which part of the Federal Reserve System is responsible for monetary policy? ›

The FOMC is the body of the Federal Reserve System that sets national monetary policy (figure 2.4). The FOMC makes all decisions regarding the appropriate position or “stance” of monetary policy to help move the economy toward the congressionally mandated goals of maximum em- ployment and price stability.

What is monetary policy and how is it implemented? ›

Monetary policy is a set of actions to control a nation's overall money supply and achieve economic growth. Monetary policy strategies include revising interest rates and changing bank reserve requirements. Monetary policy is commonly classified as either expansionary or contractionary.

What are the three mechanisms by which the Federal Reserve Board can implement monetary policy? ›

The Fed has traditionally used three tools to conduct monetary policy: reserve requirements, the discount rate, and open market operations. In 2008, the Fed added paying interest on reserve balances held at Reserve Banks to its monetary policy toolkit.

Which bank is responsible for monetary policy? ›

The Reserve Bank is also responsible for financial stability and considers it when making monetary policy decisions. A stable financial system is resilient and helps money flow even when the economy slows or there are disruptive events. Financial stability is critical to achieving a stable economic environment.

How does the Federal Reserve use monetary policy? ›

The central bank in the U.S., the Federal Reserve, uses a variety of tools to effect monetary policy. These tools include the reserve requirements required by member banks, changes in interest rates, and open market operations, which involves the purchase of Treasuries and other securities.

How does the Fed implement monetary policy during a recession? ›

The Fed has several monetary policy tools it can use to fight off a recession. It can lower interest rates to spark demand and increase the amount of money in circulation via open market operations (OMO), including quantitative easing (QE), through which additional types of assets may be purchased by the Fed.

Which monetary policy tool is the most powerful? ›

According to the Fed, there are three monetary policy tools. The best effective monetary policy tool to use is open market operations. It involves the Federal Reserve selling and buying the securities mostly for the U.S Treasury in the open market in order to regulate and control the money supply.

How can the Reserve bank use monetary policy to increase money supply in the country? ›

Conducting monetary policy

If the Fed, for example, buys or borrows Treasury bills from commercial banks, the central bank will add cash to the accounts, called reserves, that banks are required keep with it. That expands the money supply.

How does monetary policy work in a scarce reserves system? ›

In a scarce reserves system a central bank can sell bonds on the open market, increase the discount rate, and/or increase the reserve requirement. Any of those actions will decrease the money supply and increase the nominal interest rate. Expansionary Monetary Policy is used to fight unemployment.

How monetary policy is used to control inflation? ›

Inflation can be controlled by a contractionary monetary policy is one common method of managing inflation. A contractionary policy aims to reduce the supply of money within an economy by lowering the prices of bonds and rising interest rates. Thus, consumption falls, prices fall and inflation slows down.

Why will the Federal Reserve use an easy money policy? ›

The Fed looks to create easy money when it wants to lower unemployment and boost economic growth, but a major side effect of doing so is inflation. When money is easy (i.e., cheaper) to borrow, it can stimulate spending, investment, and economic growth.

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