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The Australian
Monetary System

In contrast to the U.S. system, the Australian monetary system requires no minimum reserves of its banks.  This article, based on excerpts from the website of the Reserve Bank of Australia, describes the essential features.

The monetary policy framework

The centerpiece of the policy framework is an inflation target, under which the Reserve Bank sets policy to achieve an inflation rate of 2-3 per cent on average, a rate sufficiently low that it does not materially affect economic decisions in the community.  The target provides discipline for monetary policy decision-making, and serves as an anchor for private sector inflation expectations. The target is agreed between the Bank and the Government.

The implementation of monetary policy

Monetary policy is set in terms of an operating target for the cash rate, which is the interest rate on overnight loans made between institutions in the money market.  When the Reserve Bank Board decides that a change in monetary policy should occur, it specifies a new target for the cash rate.  A decision to ease policy will reflect in a new lower target cash rate, while a decision to tighten policy will reflect in a new higher target level for the cash rate.

A decision by the Reserve Bank Board to set a new target for the cash rate is announced in a media release, which states the new target for the cash rate, together with the reasons why the Board has taken the decision to change it.  This media release is distributed through electronic news services on the day on which the change is to take effect, usually at 9.30 am, the time when the Bank normally announces its daily dealing intentions.

The Reserve Bank uses its domestic market operations, sometimes called open market operations, to influence the cash rate.  On the days when monetary policy is being changed, market operations are aimed at moving the cash rate to the new target level.  Between changes in policy, the focus of market operations is on keeping the cash rate close to the target, by managing the supply of funds available to banks in the money market - these latter operations are usually referred to as liquidity management.

The Bank's domestic market operations

The cash rate is determined in the money market as a result of the interaction of demand for and supply of overnight funds.  The Reserve Bank's ability to pursue successfully a target for the cash rate stems from its control over the supply of funds which banks use to settle transactions among themselves.  These are called exchange settlement funds, after the accounts at the Reserve Bank in which banks hold these funds. 

If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall.  Conversely, if the Reserve Bank supplies less than banks wish to hold, they will respond by trying to borrow more in the cash market to build up their holdings of exchange settlement funds.  In the process, they will bid up the cash rate.

  The demand for exchange settlement funds

There is no regulatory requirement for banks in Australia to hold exchange settlement funds.  But each bank seeks to maintain sufficient reserves to meet its daily settlement obligations.  The amount of exchange settlement funds held varies from bank to bank, reflecting differences in the size of daily interbank settlement obligations.  In the aggregate across all banks, however, demand for settlement funds tends to follow a predictable pattern.  It tends to rise when banks expect outflows for reasons outside their control, such as in the days before large tax payments are due to the Government.  It tends to fall ahead of expected injections of funds, such as by large maturities of Government bonds or other lumpy Government outlays. 

  The supply of exchange settlement funds

On the supply side, the volume of exchange settlement funds available to banks is determined by the transactions of the Reserve Bank and its customers, of which the Government is the most important.  The settlement of these transactions results in a transfer of exchange settlement funds between the Reserve Bank and the commercial banks, thereby changing the aggregate supply of balances available to the commercial banks. 

Transactions by the Reserve Bank's customers are, of course, outside the Bank's control.  So too are the Bank's issues and redemptions of Australian currency notes, as these are in response to public demand.  But the Bank can use its own market operations to offset these exogenous flows and to create additional inflows or outflows of funds as it believes appropriate. 

The Bank's dealing procedures

The Reserve Bank's domestic market operations are carried out on a daily basis by the Domestic Markets Department.  At 9.30 each morning, the Bank announces through electronic news services its estimate of the system cash opening position.  This is an estimate of the amount of exchange settlement funds expected to flow into or out of the banking system that day if the Bank did not undertake any operations.  The Bank also states whether it intends to buy (inject funds), sell (withdraw funds), or do nothing on the day.

Market participants can then submit bids or offers up to 10.00 am.  For repos, these bids and offers must specify the interest rate and term at which the participant is willing to deal.  For outright sales or purchases, they must specify the precise stock and yield. 

The operations are conducted in the form of an auction.  The Bank accepts bids or offers in descending order of attractiveness in terms of yield and maturity, up to the volume it estimates is necessary to maintain the cash rate around the target level.  It responds to counterparties as quickly as possible, and usually before 10.30 am. 

The Bank monitors market conditions throughout the day and, should conditions turn out to be different from those expected, it may re-enter the market for a second round of dealing.  As an end-of-day safety valve, banks may borrow, at their discretion, via overnight repo from the Reserve Bank at a cost of 25 basis points above the target for the cash rate.  Exchange Settlement funds are paid an interest rate 25 basis points below the cash rate. 

Under the Real-Time Gross Settlement system, banks are also able to manage their liquidity by using an intra-day repo facility with the Bank, which is made available free of charge.  RTGS works on the simple premise that if a participant does not have sufficient funds in its Exchange Settlement Account with the Reserve Bank, its payments will have to wait in queue until it has funds available.  Thus settlement risk is eliminated and the Reserve Bank's balance sheet is not put at risk by a participant's failure.

Monetary policy and debt management

Sound financial policy requires that the Government fully fund its budget deficit by issues of securities to the private sector at market interest rates, and not borrow from the central bank.  Many countries have legislation to deliver this outcome, though in Australia it is effectively achieved by agreement between the Treasury and the Reserve Bank.  This arrangement means that there is separation between monetary policy and the Government's debt management, with the Treasury directly responsible for the latter and the Reserve Bank responsible for the former. 

It is not possible to ensure that the budget deficit is exactly matched day-by-day by issues of securities to the market.  For one thing, issues generally occur only weekly.  To overcome this mismatch between daily spending and financing, the Treasury keeps cash balances with the Reserve Bank which act as a buffer.  The Reserve Bank also provides an overdraft facility for the Government that is used to cover periods when an unexpectedly large deficit exhausts cash balances.

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