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Monetary Policies hold a strong role in influencing the level of interest rate in an economy, combatting against the undesirable outcomes of fluctuations in price levels (inflation, deflation, stagflation) and ultimately boost an economy to a higher financial potential. There are numerous commonalities between the use of monetary policies between all countries, but due to economic structures, population and many other geo-political factors, this newsletter will only focus on the monetary instruments set out within Australia by the RBA (Reserve Bank of Australia).
What is the interest rate?
In simple terms, Interest rate is the cost of borrowing money, often expressed as a percentage of the amount borrowed. Interest rate establishes the demand for investors and borrowers to interact within the market through charging interest rates through lending money to borrowers. In turn, this allows investments to be made and contribute towards an economy's GDP (C+I+G +(X-M).
Exchange settlement account
Similar to the “required reserve” in the USA, an exchange settlement account is a certain proportion of funds in a Bank that is required to settle payments with other banks. This includes:
The balancing of equity from general transactions between banks
(A person with a Bank A credit cards pays someone with a Bank B eftpos machine)
The lending and borrowing of money between banks.
(Bank A borrowing funds from Bank B as short term loans)
The Exchange settlement account establishes the fundamental control of the Reserve Bank on any banks (legal financial institutions) in Australia, in combination with other regulations and actions to manipulate the amount of funds within the exchange settlement account in minimising the bankruptcy and monopolisation of a single bank, thereby sustaining and well-rounded financial sector.
Cash Rate + Policy rate corridor
Cash Rate is the desired interest rate that the RBA seeks to charge for lending and borrowing funds between banks. This interest rate is deemed the most optimal in the current economic situation so that other interest rates charged (Mortgage, deposits, investment) will all proportionally be aligned with. Inevitably, interest rates require a slight fluctuation between banks, which RBA (and most country’s federal reserves) establishes in the policy rate corridors. Policy rate corridors establish a price floor (RBA lending rate) and a price ceiling (RBA deposit rate). Through establishing such restrictions, any interest rates charged higher than the RBA lending rate or any interest loaned lower than the RBA deposited would be considered “foolish” as it could be just borrowed/Loaned to the bank itself. Thus, through establishing the policy rate corridor, the RBA is able to manipulate the interest rate charged between banks as they transact with their exchange settlement account.
As of September 2024, the current cash rate is 4.35%.
Domestic Market Operation
As the policy rate corridor only manipulates the interest to be charged, domestic market operations (DMO) allows the direct influence of manipulating the supply of funds within a bank’s exchange settlement account through either purchasing or selling financial securities (generally bonds) of a bank. When financial securities are purchased, RBA injects further funds into exchange settlement accounts and thereby reduces the level of interest rates charged. Vise versa, When financial securities are sold, funds within the exchange settlement account will be given out, thus requiring a higher interest rate to be charged to maintain balance.
Reference list
RBA (2024). Reserve Bank of Australia. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/.
reserve bank of australia (n.d.). Cash Rate Target Overview. [online] Reserve Bank of Australia. Available at: https://www.rba.gov.au/cash-rate-target-overview.html
Special Thanks to “The Market Economy 2020 edition” by Tim Dixon & John O’Mahony
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