Economics 101: Monetary Policy For Beginners

Wellsy’s Weekly Wisdom: “Let’s Drive a Stake Through The Heart of Inflation”

T. J. Ellis

AS A BUDDING YEAR 11 ECONOMIST, learning about a policy that somehow improves our lives through efficiency and prosperity has always been interesting to me; but it took me a while to grasp the concept. With some help from arguably one of the most decorated economics teachers in the school, let alone the state (goated economics department anyone?), as well as some valuable input from other Year 11 Economists, this article will help YOU to understand the mechanisms and purpose  of this magical economic instrument, known as ‘monetary policy’.

So let’s start off with a simple definition. Monetary policy, in essence, refers to a set of activities conducted by the RBA (Australia’s Central Bank), which aims to moderate the level of inflation (the costs associated with a basket of goods and services), economic growth (an increase in the level of goods and services produced domestically) and unemployment (individuals who are not willing and able to work). Monetary policy is considered a macroeconomic instrument – meaning it is concerned with the operation of an economy as a whole in the short term. Additionally, it’s commonly referred to by economists as ‘countercyclical’, meaning that it aims to stabilise the peaks (periods of significant economic growth where employment, inflation and consumer demand for products are high) and troughs (periods of significant economic recession, where inflation, employment and the demand for goods and services are low). 

Now that we have a decent idea of what monetary policy aims to achieve, let’s dive into how these macroeconomic objectives are achieved. Monetary policy uses a mechanism known as the cash rate to stimulate economic growth or recession. Essentially, it refers to the cost of borrowing associated with interbank transactions in the overnight cash market (where financial institutions and the RBA engage in the exchange of cash to meet operational obligations). So how is it actually introduced and maintained? Let’s break it down into 5 components. 

1. Price

Price in this instance refers to the cash rate – the interest rate on overnight loans in the Australian money market. As the RBA sets this rate, it is known as the main instrument of monetary policy, i.e. the main policy mechanism which allows the RBA to achieve its objectives as mentioned above. 

2. Quantity

The quantity of cash traded between banks and the RBA is called Exchange Settlement Balances. These balances are used to settle any financial obligations that banks have, and are equivalent to cash.

3. Demand

Financial institutions demand ESBs (cash) as a store of value in order to meet obligations to one and another, whether it be for operational expenses or to pay back overnight loans. The RBA estimates the demand for cash in the domestic money market and is subject to change as a result of transposed market conditions. 

4. Supply

The RBA manages the supply of ESBs in the domestic money market in order to meet a level of demand which allows the cash rate to gravitate towards its outlined target. The RBA responds to changes in demand through a process known as Open Market Operations (OMO), which are a set of transactions that the RBA conducts which involves:

1. Purchasing of bonds – The RBA may buy or sell bonds in exchange of ESBs in order to adjust the supply of cash in the money market 
2. Repurchase agreements (repos) – a transaction that has two parts. The first part involves the lending of ESBs to banks which increases cash supply and decreases the cash rate, and the second part involves the returning of ESBs and bonds back to their respective owners, reducing the supply of ESBs in the money market 
3. Foreign exchange swaps – this is another transaction that is similar to the repurchase agreement, but instead of trading government securities (bonds), foreign currency is used in the transaction. 

5. The Policy Interest Rate Corridor

The Policy Interest Rate Corridor (PICR) refers to a range in which the lending and borrowing of ESBs between the RBA and financial institutions occurs. It consists of an upper limit, known as the RBA lending rate and a lower limit, known as the RBA deposit rate. Essentially, these limits define the rate at which the RBA is willing to lend ESBs to financial institutions, and the rate at which the RBA is willing to pay financial institutions for depositing ESBs. This corridor also consists of the cash rate target, and assists in achieving this target, as banks have no incentive to borrow funds at a higher rate than the RBA lending rate, and to deposit funds with the RBA at a lower rate than the RBA deposit rate. 

So that’s a beginner’s guide to monetary policy. Hopefully this article addresses some of your concerns regarding this economic mechanism, and look forward to the next article – Fiscal policy for beginners!