macroeconomic goals and the affect on living standards

Price of cash (%)

S1 (supply of cash in the STMM is determined by the RBA)

Quantity of cash traded Market equilibriumThe RBA’s cash rate target (CRT) D1 (demand for cash in the STMM by banks) Q1 Referring to this diagram of the STMM, notice the following: • The demand for cash (D1) is determined by the needs of Australia’s commercial banks (i.e. the NAB, CBA, Westpac and ANZ) when they must make cash transfers or payments into the ESAs of other banks at the end of each day. Like normal demand lines, this has a negative slope. • In contrast, the supply of cash (S1) is directly controlled by the RBA. It is shown here as a vertical line since the RBA has a monopoly in the supply of cash. • Finally, there is the market equilibrium price or cash rate of interest for borrowing and lending in the STMM. It occurs at a point where the quantity of cash demanded and supplied are exactly equal. As its main instrument of monetary policy, the RBA Board sets and pursues a cash rate target or the ideal level for short-term interest rates that it believes will help to improve Australia’s domestic macro conditions and living standards. 4.11.2 The cash rate target and the policy interest rate corridor We have now seen that in the STMM, banks are legally required to maintain positive cash balances in their ESAs at the end of each day’s trading. For this clearing or settlement process to happen overnight, each bank must maintain a positive balance in their ESA. This requires banks to borrow and lend cash in the STMM at a level called the cash rate. As the key instrument of monetary policy, the RBA sets a desirable cash rate target for this market, that it changes from time to time in response to new economic conditions. In turn, competitive forces and consequent ripple effects cause any change in the short-term cash rate to indirectly affect other longer-term interest rates, AD, and the level of economic activity. However, there is a bit more to understanding the STMM and how the RBA seeks to push the cash rate to a level close to the RBA Board’s announced target cash rate. This level is possible because within the STMM, the RBA operates what is called the policy interest rate corridor or band of interest rates within which borrowing and lending by all banks and some other financial institutions must occur. It is a guidance system and involves the RBA setting a ceiling rate and a floor rate of interest in the STMM that sit above and below the RBA’s desired cash rate target. This is shown in figure 4.19. UNCORRECTED PAGE PROOFS

Price of cash (%)

RBA lending rate in the STMM (normally = CRT + 0.25 per centage points) S1 (supply of cash in the STMM)

Quantity of cash traded The RBA’s policy interest rate corridor Market equilibriumRBA’s cash rate target (CRT) (eg, 1.00 per cent) RBA deposit rate in the STMM (normally = CRT – 0.25* percentage points) D1 (demand for cash in the STMM) Q1 *NOTE: This diagram shows the normal RBA deposit rate in the STMM that is equal to the cash rate target minus 0.25 percentage points. However, in late 2020 when the RBA’s cash rate target was cut to 0.10 per cent, this deposit rate arrangement would have created negative interest rates. To avoid this, a decision was made to temporarily change the relationship so that the deposit rate equalled the cash rate target minus 0.10 percentage points or effectively at the time, 0.00 per cent. This change narrowed the lower end of the policy interest rate corridor. It is likely that when the cash rate target again rises, there will be a return to the normal arrangement (−0.25 percentage points). • The lending or ceiling rate is a penalty rate of interest which the RBA charges when making loans to commercial banks with cash shortfalls in their ESAs, if those banks have been unable to borrow from other banks to maintain positive balances. This upper rate is currently set at 0.25 percentage points above the cash rate target. So, for example, if the cash rate target was set at 1.00 per cent, then the ceiling lending rate would be 1.00 + 0.25 percentage points = 1.25 per cent. This costly borrowing rate acts as an incentive for banks to maintain their required exchange settlement balances and, if required, borrow from other banks with a cash surplus at a slightly lower rate. This guides the actual cash rate closer to the RBA’s cash rate target. • The deposit or floor rate is the low and uninviting interest rate that the RBA pays banks with surplus cash deposited in their ESA. Normally, this is set at 0.25 percentage points below the cash rate target. However, in the last few years where the cash rate has been almost zero (just 0.10 per cent), the RBA deposit rate was changed and was set at just 0.10 percentage points below the cash rate target (not the usual 0.25 percentage points below the cash rate: one aim was to avoid having a negative interest rate). But returning to the example shown in figure 4.19, if the cash rate target was 1.00 per cent, then the normal or standard floor deposit rate would be 1.00 – 0.25 percentage points = 0.75 per cent. This floor rate provides guidance and creates a financial incentive for banks with surplus cash balances to lend to other banks, rather than have them hold it as a deposit with the RBA where they would receive almost zero or no interest at all. Effectively, the policy interest rate corridor acts to guide and encourage commercial banks to borrow and lend close to the RBA’s cash rate target which lies between the ceiling and floor rates of interest. The corridor sets boundaries for the cash rate. As we shall see, there is no incentive for banks to trade far outside the RBA’s target rate. With all transactions in the STMM contained within this policy interest rate corridor, it allows the RBA to directly control the short-term cash rate, and through competitive forces, indirectly influence other longer-term interest rates essential for its monetary policy. UNCORRECTED PAGE PROOFS

4.11.3 The use of open market operations to maintain the RBA’s chosen cash rate target

We have now seen how the RBA has set up and uses the policy interest rate corridor to achieve an actual cash rate that closely corresponds with its announced cash rate target that is suitable for current economic conditions. However, given that the demand for cash in the STMM can change from day-to-day (e.g. perhaps in response to a financial crisis, the payment of tax to the government, or households receive welfare benefits), it is fair to ask the question — what is it that holds the actual cash rate close to the RBA’s cash rate target? For example, if the RBA did nothing, an increase in the demand for cash by banks and the private sector would tend to push up the actual cash rate, while a decrease in the demand for cash would cause it to fall. Hence, to keep the actual cash rate close to the policy target level, each day the RBA conducts open market operations (abbreviated OMO). As part of its liquidity management, these operations involve the RBA either selling Australian government bonds to the banks, or alternatively, repurchasing them (repos) from the banks, allowing the RBA to directly change the supply of cash and keep the cash rate on target. For example, figure 4.20 shows that on a given day, if there was upward pressure on the cash rate due to an increase in the demand for cash in the STMM (shown by the rise from D1 to D2), the RBA could use its OMO to repurchase government bonds from the banks. This would increase the supply of cash (shown by the rise from S1 to S2) and boost bank liquidity, exactly offsetting the increase in the demand for cash. The action would drive the cash rate back down towards the RBA’s previously announced monetary policy target (e.g. in this case, a CRT of 1.00 per cent). FIGURE 4.20 The effect of daily OMO involving RBA repurchasing government bonds to increase the supply of cash and drive the cash rate back towards the cash rate target, offsetting an increase in the demand for cash Price of cash (%) Quantity of cash S1 (original supply of cash in the STMM) S2 (increased supply of cash- RBA, OMO, involve bond repurchases) The RBA’s policy interest rate corridor The RBA’s cash rate target (CRT) (eg, 1.00 per cent) RBA lending rate in the STMM (normally = CRT + 0.25 percentage points) RBA deposit rate in the STMM (normally = CRT – 0.25* percentage points) D2 (original demand for cash in the STMM) D2 (new increased demand for cash) Q1 Q2 *Note: please see the note for figure 4.19. In reverse, and referring to figure 4.21, if there was downward pressure on the cash rate due to a decrease in the demand for cash (shown here by the drop from D1 to D0), the RBA could conduct OMO involving increased sales of government bonds to the banks, reducing their liquidity, and creating a cash shortage (shown here as the fall from S1 to S0). This would then put upward pressure on the actual cash rate, pushing it back towards theUNCORRECTED PAGE PROOFS RBA’s originally announced monetary policy target (e.g. in this case, a CRT of 1.00 per cent).

FIGURE 4.21 The effect of daily OMO involving RBA sales of government bonds to decrease the supply of cash and push the cash rate back up towards the cash rate target, offsetting a decrease in the demand for cash

Price of cash (%) S0 (decreased supply of cash- RBA OMO involve bond sales) S1 (original supply of cash in the STMM)

RBA lending rate in the STMM Quantity of cash The RBA’s policy interest rate corridor The RBA’s cash rate target (CRT) (eg, 1.00 per cent) (normally = CRT + 0.25 percentage points) RBA deposit rate in the STMM (normally = CRT – 0.25* percentage points) D1 (original demand for cash in the STMM) D0 (new decreased demand for cash) Q2 Q1 *Note: please see the note for figure 4.19. 4.11.4 What happens when the RBA decides to change the cash rate target and its monetary policy stance due to new economic conditions? As outlined earlier, monetary policy involves the RBA manipulating interest rates in a countercyclical way to help stabilise spending and economic activity. This means that typically, it will cut its cash rate target when AD is too weak (called an accommodating or looser monetary policy stance) and increase the cash rate target (called a tighter monetary policy stance) when spending is too strong. Depending on recent developments and trends in key economic indicators, the RBA Board could announce a change in the cash rate target, signalling an altered monetary policy stance. But before we look at this, it is important to remember that this cash rate target sits within the policy interest rate corridor in the STMM, between the RBA’s ceiling or lending rate, and the RBA’s floor or deposit rate of interest. The RBA decides to cut its cash rate target to stimulate AD and economic activity: In a slowdown or recession, how could the RBA adopt a looser monetary policy stance and directly cut the actual cash rate (and indirectly, lower other interest rates) to help stimulate AD and economic activity? • Referring to figure 4.22, the first step is that following their monthly meeting, the RBA Board would simply announce a reduction in the cash rate target (for example, perhaps from 1.00 per cent to 0.75 per cent), giving reasons for its decision. • Automatically, the whole interest rate corridor shifts vertically downwards as shown in figure 4.22. This creates guidance or incentives for the banks to borrow and lend at rates within this policy corridor, close to the RBA’s lower cash rate target. On the one hand, few banks will want to borrow at the RBA’s ceiling rate (e.g. the RBA’s ceiling rate = the new cash rate target of 0.75 + 0.25 percentage points = 1.00 per cent), when they can usually borrow from other banks with surplus cash, more cheaply. On the other hand, few UNCORRECTED PAGE PROOFS banks would want to deposit their surplus cash with the RBA only to receive its dismally low rate (RBA deposit rate = the new cash rate target of 0.75 per cent – 0.25 percentage points = 0.50 per cent), when they can deposit or lend to other banks with a cash shortage and gain a higher return. Again, borrowing and lending by banks in the STMM will tend to take place within the policy interest rate corridor, close to the new cash rate target.