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(i) Australia has a floating exchange rate; monetary policy involves the management of short-term interest rates to achieve

domestic policy objectives. A monetary policy instrument is a tool that is used a monetary authority in a country (for Australia, this is the Reserve Bank of Australia) to control the supply of money for the purpose of pursuing its monetary policy objectives such as maintaining the stability and efficiency of the financial markets. The Reserve Bank of Australia (RBA) is Australias central bank. It has two main responsibilities: Responsible for formulating and implementing monetary policy Responsible for the oversight and regulation of financial markets.

In this discussion question, we will only be focusing on the former. Monetary policy decisions involve setting the interest rate on overnight loans in the money market. The Reserve Bank of Australia sets the interest rates in accordance of fulfilling the objectives set out in the Reserve Bank Act 1959 The stability of the currency of Australia The maintenance of full employment in Australia The economic prosperity and welfare of the people of Australia.

Some instruments for monetary policy are: Reserve Requirement The central bank requires a commercial bank to hold a fraction of their reserves as cash to limit the amount of loans banks can make and hence reducing the money supply. Open Market Operations The central bank buy and sells bonds through the exchange settlement accounts in commercial banks to control the supply of reserves in a bank. Lending by the Central Bank The central bank may provide credit to commercial banks to control the supply of reserves. Interest Rates The central bank provides more credit to commercial banks with the most ideal interest rate (for the monetary objectives) to allow more loans to be made by that bank and affect the supply of loans, affecting quantity of savings and investments. Exchange rate The central bank buys and sells foreign exchange to control the exchange rate so that it does not affect the domestic money supplies in a negative way.

The instrument currently used by the Reserve Bank of Australia is the interest rates. The RBA controls the overnight cash rates through its Open Market Operations the RBA achieves the optimal target overnight cash rate by buying and selling bond and securities through their Exchange Settlement Accounts with the Commercial banks. This affects the commercials banks reserves and hence affects their supply of money. Monetary policy is conducted through the use of open-market operations to secure a target level for the overnight cash interest rate. As other interest rates in the economy closely follow the overnight cash rate, this gives the Reserve Bank the ability to influence all of the interest rates in the economy. (ii) The way the Reserve Bank of Australia implements the monetary policy is by controlling the cash rates of overnight loans. The cash rate is decided in a monthly meeting and maintained through Open Market Operations. Transactions are made daily through Exchange Settlement Accounts to control the aggregate balances in these accounts. The aggregate balance is the main supply of money within banks, by controlling this; the RBA can maintain the overnight cash rate it sets. The RBA can increase the level of balances to force the cash rate downwards and vice versa. The RBA pays interest 0.25% below the cash rate for money in the Exchange Settlement Account and receives interest 0.25% above the cash rate for money it lends out, this makes it more desirable to lend and borrow between commercial banks at the cash rate instead of making transactions with the RBA (this means the level of aggregate balances does not change), and hence keeping the cash rate at the desirable level. Open Market Operations are only used to maintain the cash rate as it is not required to shift to the new target rates, this is because the cost of holding or and the gain of lending out within the overnight market does not change, it will still be the margin of 0.25% so the cash rate automatically shifts to the target as soon as announcements are made. Throughout the years, different securities have been introduced for open market operations such as repurchase agreements (repos) of Commonwealth Government Securities(which were short-dated securities issued by the government), with the repurchase agreement, the RBA was able to manage when these securities can be bought back. In recent years, more securities have been introduced into this system such as domestic securities issued by central borrowing authorities of State and Territory governments and supranational organisations. The introduction of these securities means less dependence on CGS and also allows the implementation of real-time gross settlement (RTGS) for intraday transactions. This has allowed more activity in the interbank financial market and required more effort in allocations for repos. Bids and offers are

made to the RBA each day and longer termed securities are also introduced, these are non preferred terms for participants as they are less flexible but offers are still considered. Another instrument used by the RBA in occasions is the foreign exchange; the RBA may make foreign exchange swaps as substitution for the Open Market Operations, this means that the RBA uses Australian currency to buy foreign exchange, this process was introduced as there is a decrease in the amount of government securities issued, meaning the money available cannot be used to buy more domestic securities. This instrument is in the form of a swap in foreign exchange, usually with a set rate or a point in time in the future where the foreign exchange is swapped back, this is very similar to the function of a repurchase agreement. In recent years the RBA has also disclosed more information on the Open Market Operations in order to keep the participants in the market better informed and market transparent so that market forces are the main forces affecting the transactions.