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The
Australian
Monetary
System
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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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