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Chapter 15
Monetary Policy
Monetary policy refers to actions by the Reserve Bank of Australia (RBA), the federal government’s
principal monetary authority, to influence the supply and cost of credit in the economy. The main tool
of monetary policy is the Reserve Bank’s use of open market operations (i.e. the buying and selling of
Commonwealth Government Securities or CGS and Repurchase Agreements or RPAs) to influence the
cash rate or interest rate paid on overnight loans from the cash market or short term money market.
Manipulation of the cash rate is the Reserve Bank’s main instrument for changing the stance of monetary
policy. By influencing the cash rate, the Reserve Bank is able to indirectly affect the term structure of
interest rates (i.e. the range of short, medium and long term interest rates) in the financial system, which
will in turn, affect the levels of spending, output, employment and inflation in the Australian economy.
Monetary policy is used by the federal government as a ‘swing instrument’ or counter cyclical policy
to maintain a sustainable rate of economic growth in relation to changes in the business cycle e.g. the
Reserve Bank attempts to prevent the economy from experiencing the negative economic and social
effects of excessive inflation during booms, and excessive rates of unemployment during recessions.
Many central banks in OECD countries use inflation targets to conduct their monetary policies to
achieve price stability. This assists with monetary policy co-ordination between countries, and helps
to stabilise global economic activity in relation to the world business cycle. The Reserve Bank believes
that there are a number of advantages of inflation targeting in conducting monetary policy in Australia:
• The target provides an ‘anchor point’ for people’s inflationary expectations in the future;
• The target makes the conduct of monetary policy credible if the target is achieved over time;
• The target provides an operational basis for the conduct of Australian monetary policy; and
• Inflation targeting enables policy co-ordination between countries to control global inflation.
The Reserve Bank’s objective of full employment is based on the goal of minimising the rate of
unemployment close to the non accelerating inflation rate of unemployment (the NAIRU), which is
estimated to be between 5% and 6% of the workforce in Australia. The RBA believes that continuing
falls in the unemployment rate to at least the NAIRU, would achieve the goal of full employment of
labour. The unemployment rate fell from 11% in 1992 to 4.2% in 2007-08, because of sustained
economic growth and various successful microeconomic reform measures. Much of this reduction in
the unemployment rate was due to the effective use of monetary policy in containing inflation, which
helped to sustain economic and employment growth and rising living standards.
Sustainable economic growth refers to achieving a rate of growth that is consistent with rising real
incomes and employment opportunities, without accompanying increases in inflationary pressures or
a deterioration in the current account of the balance of payments and the level of foreign debt. The
Reserve Bank conducts monetary policy with a view to keeping Australia’s growth rate close to its long
term annual average of 3%. But if inflation or current account pressures arise, the Reserve Bank may
tighten monetary policy to reduce spending and ease inflation or current account pressures, which may
threaten continued sustainable growth. Conversely, monetary policy may be eased if growth is too
low and unemployment is rising to unacceptable levels and reducing living standards. The objectives,
intermediate targets and the main instrument of monetary policy are summarised in Table 15.1.
Monetary policy attempts to create an economic environment which leads to non inflationary growth.
The use of an inflation target makes the achievement of price stability a major precondition for economic
and employment growth. But conflicts between the simultaneous achievement of all these objectives
may arise. For example, if inflation becomes too high, the Reserve Bank may tighten monetary policy
to reduce the rate of spending and growth. This may cause unemployment to rise and reduce living
standards. Conversely, if growth is too low and unemployment is too high, the Reserve Bank may ease
monetary policy to encourage spending and a higher rate of economic growth. Stronger economic
growth may lead to lower unemployment, but at the cost of higher inflationary expectations and import
spending, causing a deterioration in price stability and the current account deficit.
Monetary policy is conducted in a transparent and accountable way by the RBA, with monthly Board
meetings, media releases, quarterly Statements on Monetary Policy and the Bulletin, updates and resources
on its website, and by the governor of the Reserve Bank reporting to federal parliament every six months.
Effects
1. An increase in cash or liquidity in the cash market through deposits in ESAs
2. A lower cash rate and other interest rates that make up the yield curve
a commercial bank’s ESA or a commercial bank makes a payment to the Reserve Bank. For example,
payments of taxation to the Commonwealth government by the banks will lead to a rundown in ESA
balances, and the supply of cash will decrease unless the Reserve Bank injects more cash into the system
to maintain the cash rate at its target level. Similarly, payments of pensions and other social security
allowances by the Commonwealth government to banks will increase the supply of available cash in the
banks’ ESAs. The Reserve Bank must withdraw the equivalent amount of cash to maintain the cash rate
at its target level. These are examples of daily liquidity management operations by the Reserve Bank.
The Reserve Bank controls the volume of cash through its daily open market operations. Purchases of
existing Commonwealth Government Securities (CGS) and Repurchase Agreements (‘Repos’) by the
Reserve Bank will lead to a rise in the supply of cash when payments are made into banks’ ESAs. When
the Reserve Bank sells new CGS or ‘Repos’, commercial banks will withdraw funds from their ESAs and
make payments to the Reserve Bank, reducing the supply of cash in the cash market.
All members of the Reserve Bank Information Transfer System (RITS) are eligible to deal with the RBA.
There are 230 RITS members including banks, investment houses, pension and superannuation funds.
Settlement of debts in the cash market is on a Real Gross Time Settlement (RGTS) basis, which means
that payments are settled immediately and adjustments are made to ESA balances. The RBA pays
interest on ESA funds equivalent to 0.25% less than the cash rate. Through its open market operations,
the Reserve Bank can control the volume of cash, as long as it has control over the volume of its market
operations and the Commonwealth government’s budget is balanced or fully financed by bond sales.
After the adoption of the floating exchange rate mechanism in 1983, and the deregulation of the financial
system, the Reserve Bank began to use open market operations to conduct monetary policy. Monetary
policy is more effective in this environment because the balance of payments outcome does not impact
on the money supply, nor does the government’s budget outcome. If there is a budget deficit, it is fully
financed through the issue of bonds, so that there is no need for the Reserve Bank to ‘print money’,
which would increase the money supply, lower the cash rate and put upward pressure on inflation.
Figure 15.1 illustrates how the RBA would ease the stance of monetary policy by changing the cash
rate using open market operations. The Reserve Bank would announce its intention to lower the
target for the cash rate at the beginning of the trading day in the cash market and issue a press release
to the media. It would buy existing Commonwealth Government Securities (CGS) or Repurchase
Agreements (Repos) from banks and other institutions in the cash market. This would increase the
supply of cash, because payments for the existing CGS and Repos are deposited in banks’ Exchange
Settlement Accounts, creating an excess supply of cash or liquidity. This puts downward pressure on
the cash rate, as banks would lend their excess liquidity rather than keeping it in their ESAs, because
they can earn higher market rates of interest through commercial lending of funds to their customers.
A lower cash rate would lower the cost of borrowing and put downward pressure on other short term
interest rates, which in turn would lower other medium and long term interest rates that make up the
yield curve (i.e. the relationship between short and long term interest rates). The yield curve would then
become steeper and more upward sloping as short term interest rates would be lower than long term
interest rates. This is a direct result of a more expansionary stance of monetary policy by the RBA.
Effects
1. A decrease in cash or liquidity in the cash market through withdrawals from ESAs
2. A higher cash rate and other interest rates that make up the yield curve
Figure 15.2 illustrates how the RBA would tighten the stance of monetary policy by changing the cash
rate using open market operations. The Reserve Bank would announce its intention to raise the target
cash rate at the beginning of the trading day in the cash market and issue a press release to the media.
It would sell new Commonwealth Government Securities (CGS) or Repurchase Agreements (Repos)
to banks and other institutions in the cash market. This would decrease the supply of cash because
payments for the newly issued CGS or Repos would be withdrawn from banks’ Exchange Settlement
Accounts, creating a deficit of cash or liquidity. This would put upward pressure on the cash rate, as
banks would have to borrow liquidity to keep their ESAs in surplus as required by the RBA. A higher
cash rate would raise the cost of borrowing, and put upward pressure on other short term interest rates,
which in turn, would raise other medium and long term interest rates that make up the yield curve. The
yield curve would then become flatter and more downward sloping as short term interest rates would be
higher than long term interest rates, a direct result of a more contractionary stance of monetary policy.
If there is a neutral stance of monetary policy, then there is no need for the RBA to alter the cash rate.
An excess demand for cash will be met by Reserve Bank open market operations to increase the supply
of cash (through purchases of CGS), and an excess supply of cash will most likely be met with Reserve
Bank actions to reduce the supply of cash (through sales of CGS). Such actions by the Reserve Bank are
designed to create a stable cash rate and are part of its daily liquidity management operations.
Another way of analysing the conduct of open market operations by the RBA to influence the cash rate
is shown in Figure 15.3. An increase in the supply of cash from S to S2 through open market purchases
of existing CGS or Repos would lead to a lower cash rate from r to r2, and an easing of monetary policy.
On the otherhand, a decrease in the supply of cash from S to S1 through open market sales of new CGS
or Repos would lead to a rise in the cash rate from r to r1, and a tightening of monetary policy.
Figure 15.3: Changes in the Cash Rate Caused by Changes in Monetary Policy
r1
r
r2
0 Quantity of cash
Substitution/
Cost of Capital
Intermediaries’ Domestic
Cash Flows
Rates Expenditure
Output
Market Rates/
Term Rates Asset Prices/
Wealth
Prices
Net Foreign
Expectations Exchange Rate
Demand
Changes in Output,
Employment,
Changes in the Changes in other Changes in
Prices, the
Cash Rate Interest Rates Domestic Spending
Exchange Rate and
Expectations
The monetary policy transmission mechanism is illustrated in Figure 15.5, with changes in interest
rates ultimately affecting domestic expenditure. For example, higher interest rates used to contain
inflation will reduce consumption, investment, government and import expenditure. Lower domestic
spending will in turn reduce output and economic growth. If output growth slows, so will employment
growth and inflationary expectations. The exchange rate will also appreciate, causing a loss of export
competitiveness. So overall, higher interest rates have a contractionary effect on the economy, and this
would help to reduce inflation and assist the Reserve Bank in achieving the objective of price stability.
Conversely, lower interest rates used to stimulate economic growth will increase consumption,
investment, government and import expenditure. Higher domestic spending will increase output and
economic growth. If output growth rises, so will employment growth and inflationary expectations. The
exchange rate will depreciate, causing a rise in export competitiveness. So overall, lower interest rates
have an expansionary effect on the economy, helping the RBA to reduce the rate of unemployment.
REVIEW QUESTIONS
THE OBJECTIVES, IMPLEMENTATION
AND IMPACT OF MONETARY POLICY
1. Define monetary policy and explain how is it conducted by the Reserve Bank of Australia.
2. What are the objectives of monetary policy? Refer to Table 15.1 and discuss the objectives,
intermediate targets and the main instrument of monetary policy.
3. Why does the Reserve Bank use an inflation target for the conduct monetary policy?
4. What are the advantages of using an inflation target for the conduct of monetary policy?
6. What is meant by the Reserve Bank’s open market operations? What is meant by the cash
market? What are the main determinants of the demand for cash and the supply of cash?
7. Refer to Figures 15.1 and 15.3 and the text, and explain how the RBA could lower the cash rate
and ease the stance of monetary policy. What would be the economic effects of this policy?
8. Refer to Figures 15.2 and 15.3 and the text, and explain how the RBA could raise the cash rate
and tighten the stance of monetary policy. What would be the economic effects of this policy?
9. Discuss the transmission channels of monetary policy in Figure 15.4 and explain how an easing
or a tightening of monetary policy could affect economic activity and the exchange rate.
10. Refer to Figure 15.5 and explain how changes in the stance of monetary policy can help the RBA
to achieve its objectives. Discuss recent trends in monetary policy by reading pages 318-321.
Table 15.2: Changes in Monetary Policy - Movements in the Cash Rate 2008-2012
2. Tightening cycle due to higher inflation: total increase in the cash rate of 1.75%
October 7th 2009 3.00% 3.25% Tightening +0.25%
November 4th 2009 3.25% 3.50% Tightening +0.25%
December 2nd 2009 3.50% 3.75% Tightening +0.25%
March 3rd 2010 3.75% 4.00% Tightening +0.25%
April 7th 2010 4.00% 4.25% Tightening +0.25%
May 5th 2010 4.25% 4.50% Tightening +0.25%
November 2nd 2010 4.50% 4.75% Tightening +0.25%
3. Easing cycle due to a deteriorating global economy: total cut of 1.25% in the cash rate
November 2nd 2011 4.75% 4.50% Easing -0.25%
December 7th 2011 4.50% 4.25% Easing -0.25%
May 2nd 2012 4.25% 3.75% Easing -0.50%
June 6th 2012 3.75% 3.50% Easing -0.25%
Source: Reserve Bank of Australia (2012), Statement on Monetary Policy, August.
Cash Rate
7
2
2008 2009 2010 2011 2012
2. High interest rate or tightening cycle (October 2009 to November 2010): The Reserve Bank
tightened monetary policy between October 2009 and November 2010, with seven rises in the cash
rate, each of 0.25% (refer to Table 15.2). This increased the cash rate from 3% to 4.75%, as the
Reserve Bank tightened credit conditions to prevent a rise in inflation and inflationary expectations
associated with a stronger than expected economic recovery and rising house prices. However
further rate rises did not occur after November 2010, as debt crises in Europe and the USA led
to increased financial market volatility in 2011, and floods and Cyclone Yasi in Australia reduced
economic growth in 2011. The cash rate was left at 4.75% between November 2010 and November
2011 as more data became available about the strength of global recovery, the worsening European
Sovereign Debt Crisis and the uneven pattern of growth in Australia due to the high exchange rate.
3. The uncertain outlook for the global economy and the uneven pace of recovery in the Australian
economy led the Reserve Bank to ease monetary policy in November and December 2011 by
reducing the cash rate by 0.25% in each month (refer to Table 15.2). This provided support to
borrowers and helped to maintain consumer confidence. The Reserve Bank held the cash rate at
4.25% in early 2012 pending the release of more data on the world and domestic economies.
In May 2012 the Reserve Bank Board lowered the cash rate by 0.5% as it became clear that the
worsening European Sovereign Debt Crisis was reducing the prospects for world growth and causing
volatility in financial markets. In addition the uneven pattern of growth in the Australian economy
was being sourced from consumer caution over spending decisions, and the impact of the high
value of the Australian dollar in reducing the competitiveness of some firms in the manufacturing,
tourism and education sectors. The Reserve Bank lowered the cash rate by 0.25% in June 2012,
giving further support to borrowers and putting downward pressure on the exchange rate.
Figure 15.6 shows the trends in the cash rate, 90 day bank bill rate and the 10 year bond rate for the
three interest rate cycles between 2008 and 2012. These cycles reflected changes in economic conditions
over time, and the pre-emptive use of monetary policy for counter cyclical stabilisation of the economy:
• A more expansionary stance of monetary policy was used between September 2008 and April 2009
to support confidence, domestic demand and employment because of the Global Financial Crisis.
• A more contractionary stance of monetary policy was used between October 2009 and November
2010 as economic recovery firmed and inflationary pressures rose including higher house prices.
• A more expansionary stance of monetary policy was used between November 2011 and June 2012
as inflation pressures eased, but the outlook for global growth became more uncertain because of
the impact of the European Sovereign Debt Crisis on world trade and financial flows. A pattern
of unbalanced growth had also emerged in the Australian economy due to increased consumer
uncertainty and the loss of competitiveness in some industries because of the high value of the
Australian dollar raising export prices and reducing import prices.
Monetary Policy and the Global Financial Crisis and Recession in 2008-09
The stance of Australian monetary policy changed in September 2008, with the first cut in the official
cash rate of 0.25% since December 2001. This was a response by the Reserve Bank to the deteriorating
outlook for the global economy and the prospects for much weaker growth in the Australian economy
due to the initial US sub prime mortgage crisis and then the Global Financial Crisis (GFC).
The tightness in global and domestic credit markets, combined with higher fuel costs and falling house
prices exerted a restraint on domestic spending and this led to a softening in business activity. The
Reserve Bank believed that these factors, together with slower global activity would lead to inflation
falling below 3% by 2010. At the October 2008 Reserve Bank Board meeting the decision was taken
to lower the cash rate by 1% to 6%, because of deteriorating international economic conditions, with
large contractions in industrial output in the USA, Euro Area countries, Japan and major emerging
economies such as China, India and ASEAN. In addition, financial markets were very turbulent as the
supply of credit was restricted in wholesale markets and the share prices of major companies remained
volatile. Further large easings in the cash rate of 0.75% in November 2008, and 1% in December 2008,
were made by the Reserve Bank because of the following factors:
• Continuing turbulence in world financial markets with extreme volatility in equity prices.
• Significant weakness in global output and trade leading to falling commodity prices.
• Fragile consumer and business confidence because of evidence of weak economic conditions.
• A moderation in domestic demand in Australia despite recent reductions in interest rates, the
depreciation of the exchange rate and the government’s use of a fiscal stimulus package.
• A weakening labour market with a lower demand for labour and rising levels of unemployment.
In the December 2008 decision to ease the cash rate the Reserve Bank Governor, Glenn Stevens, said:
“Weighing up the international and domestic developments of recent months the Board judged that
a further significant reduction in the cash rate was warranted now, to take monetary policy to an
expansionary setting. As a result of today’s decision the cash rate will be at its previous cyclical low
point. Given trends in money market yields, most lending rates should fall significantly and will also
reach below average levels.”
Further cuts in the cash rate of 1% in February 2009 and 0.25% in April 2009 continued the downward
trend in the cash rate to 3% (refer to Figure 15.7). The large easing in monetary policy helped to put
downward pressure on household mortgage interest rates, and interest rates on business lending such as
overdrafts and term loans (see Figure 15.8), helping to provide lower costs to borrowers.
Figure 15.7: Cash Rate Target Figure 15.8: Housing and Lending Rates
From historical experience tightenings of monetary policy have more effect on gross national expenditure
than do easings of monetary policy. For example, the easings in monetary policy after the 1991 recession
took two to three years to stimulate domestic demand and economic growth and it was not until 1994
that an upsurge in economic activity finally led to a fall in the unemployment rate. In contrast, the two
interest rate rises at the end of 2003 had a fairly immediate impact in reducing the growth of housing
related spending, which eventually led to a slowing in the rate of increase in house prices across Australia.
Monetary policy is often referred to as a ‘blunt instrument’ since an increase in interest rates may
impact adversely on all types of spending (e.g. consumption, imports, investment and housing) even if
the initial problem is excessive spending of one type, such as spending on housing, leading to speculative
activity and higher house and apartment prices. Using higher interest rates to contain spending on
housing, could also reduce business investment and cause a rise in the level and rate of unemployment.
Monetary policy is said to be both an art and a science, requiring correct knowledge of the monetary
transmission mechanism: when and by how much to change the stance of policy to achieve the desired
objectives. The science of monetary policy has improved (i.e. knowledge of the transmission mechanism
or transmission channels), but the art of monetary policy (i.e. knowing when to ease or tighten and by
how much) is still dependent on the interpretation of a wide range of often conflicting data and the
accuracy of forecasts made by the Reserve Bank of Australia, Treasury and other government agencies.
Monetary policy has also assumed the key role of containing wages growth by dampening inflationary
expectations which may be built into wage negotiations. The Australian government therefore relies on
monetary policy to a large extent to control wage or cost inflation. However monetary policy cannot be
used to reform the labour market, and in the absence of a prices and incomes policy, monetary policy at
best can only be used to contain wage expectations. The Reserve Bank monitors wages growth carefully
through changes in the Wage Price Index or WPI. Wages growth is an important factor in the setting of
monetary policy in relation to the inflation target. Unofficially the Reserve Bank would be concerned
about achieving its inflation target if wages growth exceeded 4% per annum on average in Australia.
Discretionary fiscal policy has been used to achieve budget surpluses, retire public debt and increase
the government’s net financial worth position over time. This policy of fiscal sustainability provides
greater scope for interest rates to be cut by the Reserve Bank (if its inflation target is being achieved) to
promote sustainable economic growth. If the Australian government is accumulating budget surpluses,
this helps to raise national saving, making more funds available for private sector borrowing.
If the government does not compete for existing funds in financial markets to fund a budget deficit,
this also relieves pressure on interest rates. Therefore some degree of co-ordination between monetary
and fiscal policy is necessary for each to be effective. This occurred in 2008 and 2011 when a more
restrictive fiscal stance was adopted to reduce the growth in public demand, helping to ease inflationary
pressures. Therefore the stance of fiscal policy in the 2008-09 and 2011-12 budgets was supportive
of the more restrictive stance of monetary policy adopted by the Reserve Bank in 2007-08 and 2009-
10. In contrast, the settings of both monetary and fiscal policies were eased in 2008-09 as the Global
Financial Crisis and recession threatened to restrict Australia’s rate of economic growth and increase
unemployment. The use of large easings in monetary policy, and fiscal stimulus packages in 2008-09,
led to more expansionary settings of both macroeconomic policies to support economic growth.
A final difficulty in framing domestic monetary policy is that it must take into account developments in
the global economy, over which the Reserve Bank has little to no control. External shocks transmitted
to the Australian economy such as the following have made the conduct of monetary policy and the
achievement of monetary policy objectives more difficult in Australia in the last decade:
• The Asian economic crisis in 1997-98 and the US recession in 2001;
• The global resources boom, rising oil prices and higher terms of trade between 2005 and 2007;
• The US sub prime mortgage crisis, and the Global Financial Crisis and recession in 2008-09.
• The European Sovereign Debt Crisis and slow US economic recovery between 2010 and 2012.
The first two shocks necessitated a more expansionary stance of monetary policy to support domestic
growth, whereas the third shock necessitated a more contractionary stance of monetary policy to restrain
domestic growth and inflation. The fourth shock of the US sub prime crisis and Global Financial Crisis
and recession in 2008-09 were transmitted to Australia in the form of higher credit charges, and a fall in
world output and trade. The Reserve Bank supported financial markets with injections of liquidity and
then began using a very expansionary stance of monetary policy to support activity and employment.
The International Monetary Fund (IMF) undertook a comprehensive study in 2003 to compare the
performance of inflation targeting countries with non inflation targeting countries in the 1980s and
1990s. It found substantial empirical evidence to support the effectiveness of inflation targeting regimes.
The comparative Reserve Bank data in Table 15.3 on Australia’s inflation and growth performance
between 1980-92 (no inflation target) and 1993-2003 (inflation target) supported the IMF’s conclusion:
Table 15.3: Australian Inflation and Real GDP Growth (average % change)
• Annual average inflation fell from 7.2% to 2.3% in the inflation target period;
• The variability in inflation fell from 2.4% to 0.6% in the inflation target period;
• Real GDP growth increased from an average of 2.8% to 3.9% in the inflation target period; and
• The variability in GDP growth fell from 2.7% to 1.1.% in the inflation target period.
REVIEW QUESTIONS
RECENT TRENDS IN MONETARY POLICY
1. Describe the main features of the three interest rate cycles in Australia between 2008 and 2012.
2. Explain the reasons for the Reserve Bank easing the stance of monetary policy in 2008-09 and
2011-12.
3. Explain how the conduct monetary policy has been made more transparent and accountable.
Refer to Extract 15.1 on the Statement on Monetary Policy (2010) in your answer.
“Under the inflation targeting framework, the objective of monetary policy remains to contain inflation
in the medium term, thereby ensuring one of the factors for the economy to achieve its maximum
sustainable growth potential.”
Source: Reserve Bank of Australia (2009), Bulletin, August.
Refer to the table above of selected economic indicators for Australia between 2008
and 2011 and the commentary on monetary policy, and answer the questions below. Marks
2. Explain TWO reasons why the Reserve Bank uses an inflation target to conduct (2)
monetary policy.
3. Explain how the Reserve Bank can influence interest rates in Australia. (3)
4. Discuss TWO reasons why the Reserve Bank cut the cash rate between 2008 and 2009. (4)
“In response to the rapid change in the global environment that took place following the financial
events of last September, the Board reduced the cash rate by 4.25% in six steps between September
2008 and April 2009. Consistent with the Board’s forward looking approach to monetary policy,
this rapid and large easing of monetary policy was made in anticipation of a very weak domestic
economy and a decline in inflation from elevated levels.
At its meetings since April 2009, the Board has held the cash rate constant at 3%. It judged that
the inflation outlook provided some scope for a further reduction in the cash rate below 3% if that
was needed.”
Source: Reserve Bank of Australia (2009), Statement on Monetary Policy, August.
Analyse the impact of a more expansionary stance of monetary policy to support economic
activity and employment in the Australian economy during the Global Financial Crisis.
CHAPTER SUMMARY
MONETARY POLICY
1. Monetary policy refers to actions by the Reserve Bank of Australia through changes in the cash rate
to influence the supply and cost of credit in the economy.
2. The main instrument of monetary policy is the use of open market operations to influence the cash
rate. The cash rate is the official rate of interest paid on overnight loans from the cash market.
Changes in the cash rate will eventually alter other market interest rates in the financial sector.
3. The main objectives of monetary policy include price stability, full employment and economic
growth. These are set out in the Reserve Bank Act 1959.
4. The centrepiece of the operation of monetary policy is the Reserve Bank’s use of an inflation target
of 2% to 3% CPI inflation on average over the economic cycle. The inflation target provides an
anchor point for inflationary expectations in the Australian economy and an operational target for
the conduct of monetary policy.
6. Monetary policy is implemented by the Reserve Bank through the use of open market operations.
This involves the buying or selling of Commonwealth Government Securities (CGS) and Repurchase
Agreements (Repos) by the Reserve Bank with counter parties in the cash market.
7. To ease the stance of monetary policy the Reserve Bank would buy CGS and Repurchase
Agreements, adding to the cash balances in banks’ Exchange Settlement Accounts. This would
lead to a surplus in cash and a fall in the cash rate. To tighten the stance of monetary policy the
Reserve Bank would sell CGS and Repurchase Agreements, reducing the cash balances in banks’
Exchange Settlement Accounts. This would lead to a deficit in cash and a rise in the cash rate.
8. Changes in the cash rate and the stance of monetary policy flow through to other market interest
rates and affect the cost of credit in the economy. This in turn affects the growth of domestic
spending, which ultimately brings about changes in output, employment, prices, the exchange rate
and inflationary expectations. Through this transmission mechanism the Reserve Bank attempts to
achieve its objectives of price stability, full employment and economic growth.
9. Between September 2008 and April 2009 the Reserve Bank eased the stance of monetary policy
by reducing the cash rate from 7.25% to 3% because of the impact of the Global Financial Crisis
and recession in slowing economic activity and employment growth in the Australian economy.
The cumulative fall in the cash rate of 4.25% had the effect of reducing costs to borrowers.
10. Between October 2009 and November 2010 the Reserve Bank tightened the stance of monetary
policy by increasing the cash rate by 1.75% to contain inflationary pressures accompanying the
Australian economic recovery and the resources boom after the Global Financial Crisis.
11. The stance of monetary policy was eased between November 2011 and June 2012 because the
European Sovereign Debt Crisis reduced the prospects for global growth and trade, and the high
value of the Australian dollar reduced competitiveness in some trade exposed industries.
12. Monetary policy acts with a long and variable lag, but has generally been effective in containing
inflation, sustaining growth and employment in the Australian economy since the adoption of
inflation targeting in 1993. These outcomes are supported by IMF research on the use of inflation
targeting by countries to conduct their monetary policies effectively.