Monetary policy refers to the actions taken by the Reserve Bank of Australia (RBA) to affect the money supply in in the money market (also known as the cash market) to achieve low inflation and sustainable growth.

The Reserve Bank sets a targeted “cash rate” (the market rate of interest on overnight funds), increasing and lowering this rate to affect demand, economic growth and inflationary pressures.

Since monetary policy affects the rates levied on our borrowings and savings, and pretty well underpins every financial transaction we make on a daily basis, it’s worth understanding the basics.

It works simply enough: just as you hold an account at a bank, every bank in turn holds an account at the RBA, technically termed an exchange settlement account. The RBA is the banker to the commercial banks and therefore facilitates transfers of funds between them.

As an example, let’s say you buy a television for $1,000 from your local electronics shop that holds an account at St George Bank, and you pay for it using your Westpac debit card. At the end of the business day, the RBA will credit St George’s exchange settlement account by $1,000 and debit Westpac’s account by $1,000. Basically, these funds are shuffled between banks to match the transactions that take place in the private sector on a daily basis.  

Banks also borrow and lend money to each other on a daily basis with interest charged at the cash rate.

Exchange settlement accounts are also used for transactions between the RBA and commercial banks. Let’s say you bank with Westpac and it’s tax time so you owe tax to the Federal Government. Westpac’s exchange settlement account held at the RBA will be debited by the amount of tax you owe - and since the RBA is also the banker to the Federal Government - the Government’s account with the RBA is credited by an equal amount. But I hear you ask: how does this relate to how the RBA’s cash rate affects the average person’s mortgage repayments?

It wouldn’t be an economics lesson without demand and supply analysis, and in this instance we’re talking about the demand and supply of money determining its price, or the cash rate. Put briefly, a decrease in the supply of money would cause the cash rate to rise and an increase in the supply of money would cause the cash rate to fall (all other things being equal).

Therefore, when the RBA wants to increase the cash rate, as occurred in May, it will reduce the total amount of funds held in exchange settlement accounts at the RBA. Conversely, when it wants to reduce the cash rate, as occurred between February and December 2001, it increases the aggregate level of balances held in exchange settlement accounts.

Without getting into too much detail here, the technique used by the RBA to alter the amount of funds held in exchange settlement accounts is via purchasing and selling Commonwealth Government Securities (CGS) and Repurchase Agreements (repos).

Put simply, when it wants to tighten monetary policy – which is seemingly its intention at present – it will sell CGS and repos in the money market. The banks withdraw money from their exchange settlement accounts to pay for them and voilá: the supply of funds in these accounts drops and the cash rate increases pretty well automatically. If the RBA announced its intention to reduce the cash rate, it would buy second hand CGS and repos from financial institutions in the money market – which pumps money into the system as the RBA transfers funds into the banks’ exchange settlement accounts. The RBA engages in this activity, technically termed “open market operations,” not only when it wants to shift the cash rate up and down, but also to maintain the cash rate at its current level on a daily basis.

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