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“Everyone my name is katherine and i work in the domestic nmarkets department at the the reserve bank in this video. I m going to be explaining nhow. The reserve implements monetary policy or in other words how we keep the cash rate non target. I think.
This is something which isn t widely nunderstood. So i m really excited to have the opportunity to discuss this with you i think the best place to start is with this nstandard textbook model for the australian cash market. So. This is the stylised demand and supply ndiagram for a corridor system.
X. Axis here. We have the amount of cash or nliquidity. Which is available and on the vertical axis.
We have the price in this case. The cash rate or the interest nrate paid on overnight unsecured loans between banks now you may know that the reserve bank board nmeets once a month and in that meeting. They decide what the target rate for the cash rate. Nshould.
Be now australia runs a corridor system. And i ve indicated this by two dotted lines non our diagram. The corridor forms a ceiling and a floor on nthe cash rate target at 25 basis points above and 25 basis points below and actually banks have no incentive to trade noutside. This range.
They know they can always borrow cash from nthe reserve bank at 25 basis points above target and they can always leave excess reserves. Nat. The reserve bank for 25 basis points. Below.
So all market activity is actually contained nwithin this range. Now. I ve also included a standard downward nsloping demand curve here. We don t directly observe demand.
But we interact with the market every day nso. We get a pretty good gauge of what demand is and finally we have the supply curve and this is really the domain of the domestic nmarkets department. It s our job to ensure that the supply of ncash is appropriate to meet demand and keep the cash rate close to target or in other words. It s our job to make sure nthe supply curve intersects that demand curve close to that target rate.
Now demand can and does move around in this nmarket. And if demand moves. Then the reserve bank nwill respond by altering supply..
So for example. If demand were to increase nin. This market. The reserve bank would respond by increasing the supply of cash as well to nkeep that cash rate near our target.
This is exactly what happened during the financial ncrisis banks wanted to hold a bit of extra cash as nprecautionary balances and the reserve bank made sure to supply some extra cash to the nmarket now. I d just like to clarify exactly what nwe mean by cash or liquidity. In this case. So to be very clear.
What i m talking about nis. Actually exchange settlement balances or es balances for short. So. All of the banks.
And some other financial ninstitutions. Each have accounts at the reserve bank in these accounts are the reserve bank s nown electronic currency. Called exchange settlement balances. Now these es balances are really for the banks.
Nto. Make payments between each other. So for example. If bank a wanted to pay bank nb they d do this through es balances bank a s account would be debited and bank nb s account would be credited.
Now most es balances are actually held for nbalances after the close of the cash market. These actually have no monetary policy impact nso. We can ignore these for the purpose of this presentation. A very small portion of these es balances nare actually what we call a surplus es balance.
They re held for banks to meet their payment nobligations and any ad hoc increases in demand. They re really there to make sure the payment. Nsystem runs as smoothly as possible now the reason we care about these surplus nes balances is that if you add up the surplus at each individual bank. The total of these nbalances would be the supply of cash in the market or the supply from that supply and ndemand diagram.
I showed you earlier now i can actually show you what surplus es nbalances or the supply of liquidity. Has been in the market since the year 2000 you can see at the moment. We re sitting at naround 2 billion. But at one point in time we were up at over 16 billion and that was nin the middle of the financial crisis as i mentioned earlier the banks wanted to nhold a lot of extra precautionary balances at that time now.
This is actually one of my favourite graphs and the reason for this is that it s really nuseful in debunking. What i think is one of the biggest myths around monetary policy and that is that the reserve bank changes nthe cash rate target by changing the supply of cash if i add on the cash rate target here you ncan. See that there are actually a lot of times..
When the cash rate target is changing. But nthe supply of cash is remaining the same. So if we don t change. The cash rate target nby changing the supply of cash.
How do we do it. Well. I ll be honest with you the corridor system actually does all of the nwork for us these surplus es balances are actually remunerated nat that floor of the corridor so that s 25 basis points. Below.
That target nrate so regardless of the level of the cash rate ntarget. There s always a 25 basis point penalty for holding that cash at the reserve bank. So actually demand remains unchanged. When nwe change.
The cash rate target and the market automatically reprices for us. So. A day. When the cash rate.
Target changes nlooks very much like any other for the domestic markets department. So let s have a bit more of a look at surplus nes balances. I ve said before that if you add up all the nsurplus es balances you ll get the supply of liquidity in the market. I ve represented this visually by a beaker nfilled with liquid or liquidity in this case.
Now. The reserve bank. Gauges demand in the nmarket and works out the appropriate level of supply to keep that cash rate close to ntarget and we call this our target level of liquidity. I ve marked that in this little black line non the beaker here so all we need to do to keep the cash rate nclose to target is to ensure that the supply of cash remains.
Near that target level of nliquidity. How hard can that be well actually. It s not as easy as it sounds and that s because there are all these other naccounts sitting at the reserve bank of australia. So we have a few things here we have some accounts belonging to the australian ngovernment.
Some belonging to the reserve bank itself and finally some belonging to our other clients. Nmostly foreign central banks. Now the key thing about these other accounts nis they sit quite separately to surplus es balances and we care primarily about how much liquidity nis in that left hand beaker. So.
If for example two banks made transactions. Nbetween each other all within that left hand beaker. The total supply of cash in the market nwould remain..
The same so we don t care too much about those transactions. Similarly. If there s a transaction. All within nthat right hand beaker say between the government and the rba then that would leave surplus nes balances unchanged as well so we don t care too much about those transactions neither the transactions we do really care about are nthose which occur between these surplus es balances and the government or other accounts nbecause these transactions will actually change the total amount of surplus es balances in nthe market and change our supply of cash available let s break this down.
A little bit more suppose for example. We have a transaction nwhich is going from one of these government or other accounts to the surplus es balances an example of this might be when the go makes na payment when they pay pensions or when they give a grant to a school in this case. The funds would go from one nof these government and other accounts to surplus es balances so the government account would decrease and nsurplus es balances would increase so this would increase the total of supply nin the market because we re adding liquidity to the market nwe would call this. A liquidity injection.
Another example of a liquidity injection. Would nbe. When a government bond matures the funds are returned to the bond holder nand surplus es balances increase the reverse works exactly the same way a transaction which goes from surplus es balances nto one of these government or other accounts will decrease the total amount of surplus nes balances in the market and hence decrease the supply of liquidity because liquidity is being removed from the nmarket. We would call this a liquidity withdrawal an example of a liquidity withdrawal would nbe when individuals or companies pay tax to the government this removes supply of liquidity from the nmarket.
So the job of the reserve bank is really to nforecast all the transactions. We think are going to happen on a given day. What we ll do is add up all of those transactions nand work out on net. What we think the change in liquidity is going to be so for example.
If we were to add up all of ntoday s transactions we might find that we expect surplus es balances to be about 1 nbillion below that target level so what does that mean. The reserve bank will actually have to come nalong and add back in that liquidity we call this liquidity management so we ll increase surplus es balances back nup to that target level to keep the cash rate close to our target rate. The reserve bank conducts its liquidity management nthrough its open market operations or omos for short and we have three different tools nwhich. We can use in our omos.
The first are our outright government bond npurchases then we have our reverse repurchase agreements. Nor repos and finally our foreign exchange swaps or nfx swaps and i m going to primarily discuss. The first ntwo of these so outright government bond purchases work nexactly how they sound. The reserve bank.
Receives a bond and provides ncash to the market at an exchange so this is actually adding surplus es balances nto the market thinking back to our beakers example this nwould be an increase in that surplus es balances that left hand beaker now this is a liquidity injection so it can nbe used to offset a transaction. Which has drained liquidity from the market. For example. When individuals or companies.
Npay tax to the government now these outright government purchases aren t ntypically used on a daily basis. But we would use them in large volumes ahead of a government nbond maturity to give you a bit of an idea we would probably nsterilise about two of these each year the tool that we would use most frequently nare actually these reverse repurchase agreements or repos so let s just make sure we re on the same npage with what a repo actually is a repo is a contract between two counterparties nwhere. One agrees to sell a bond to the other and repurchase. It at a specified price at nsome date in the future.
So this is like a loan. Which is being secured by a bond and this transaction. Actually has two legs..
The first leg looks very much like an outright nbond purchase. The reserve bank receives the bond and supplies ncash to the counterparty so this add liquidity to the market and increases nsurplus es balances on the second leg this transaction will unwind so the reserve bank will give back the bond nand receive its cash back in return so this second leg. Removes liquidity from nthe market and is a liquidity withdrawal. So this leg can be used to offset transactions.
Nwhich have added liquidity to the market for example. When the government makes a payment now you can see that these repos are actually nquite. A flexible tool. The two legs have transactions going in opposite ndirections.
So they can be used to offset transactions. Which go in two different directions and for that reason the reverse repurchase nagreements are used most frequently by the reserve bank by which i mean typically on na daily basis. Now our third and final tool are our foreign nexchange swaps. The fx.
Swaps work. Very similarly to a repo. The only difference is instead of bonds being nused to collateralise a loan. We actually use foreign exchange instead so for example we might use us dollars or njapanese.
Yen. Now these are our three open market operations ntools and we would use these tools to manage liquidity in the market. To make sure. The supply.
Nof cash. Meets demand and keeps our cash rate. Close to that target level. So let s have a look at how we ve gone.
This is the cash rate. The actual cash rate showing in black and nthe cash rate target shown in red here you can see that over time the actual cash nrate has got a lot closer to the target. And that s because the market has learned over ntime that they can rely on the reserve bank to supply the appropriate amount of liquidity in recent times. You can see that the cash nrate has remained really quite consistent with the target.
And that s because we ve made sure that the nsupply of cash is appropriate for demand and we can keep that cash rate close to target. So that s everything from me. This is how we keep the cash rate close to ntarget or how monetary policy is implemented if you do have any more questions feel free nto get in contact with us and we d be happy. ” .
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