Policy Approach

Tools

Many students believe that the terms “monetary policy” and “interest rates” are interchangeable, but this is not correct. Although interest rates represent the most important tool that the RBA uses when implementing monetary policy, they actually have at their disposal a much broader range.

The RBA is able to indirectly affect the credit creation process through persuasion. Four times each year, the RBA will publish the quarterly Statement on Monetary Policy. This document is a thorough analysis of the Australian economy as it stands at that point in time. It provides an insight into the minds of the board members, and as a result it will provide strong clues as to the future direction of interest rate changes. Those who read the statement may alter their actions according to these suggestions. For example, if it is likely that interest rates will rise in the near future, this will affect effective rates of return in the bond market – demand for these investments will increase and the probable future return will be factored in to the current price. This will also result in a decrease in borrowing, as businesses (in particular) will wait until the rate of interest is stable. In this way, the RBA is able to use persuasion to have an impact on the Australian economy.
Each year, it is also likely that the RBA will intervene to some extent in the foreign exchange market. When the Australian dollar was floated in 1983, the RBA retained the right to intervene in the market for AUD. This is referred to as a “dirty float”. As a result, the RBA is able to directly influence the value of the AUD on the foreign exchange market by buying or selling currency. Buying Australian dollars will cause the value of the currency to appreciate. This can be reflected on a supply and demand graph – by taking the currency out of circulation the RBA is effectively reducing the supply, leading to a higher price. The opposite is also true - selling Australian dollars will increase the supply, and the price will fall.
Finally, the RBA is also able to indirectly influence the cash rate, and through this mechanism all other interest rates payable in the economy will also change. It has already been established in Unit 3 that interest rates can have an enormous impact on aggregate demand. As such, any changes made by the RBA will flow through to affect all of the goals as set by the Australian government. At this stage it is important to note that the RBA does not just “set” the cash rate. This is a very complicated process that involves the buying and selling of second hand government securities to try and alter the rate indirectly. This is referred to as “Open Market Operations”.

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