Open Market Operations

A common misconception is that the RBA is able to just “set” the cash rate. In reality, the cash rate is also referred to as the “target” rate – it is the rate for which the RBA is aiming on a daily basis. The actual rate will be determined by the net impact of a large volume of transactions in the overnight money market trading in second hand government securities. This is a complex process, but the general method can be understood when you understand that the “price” of money (the interest rate) is a consequence of a change in the supply of money. If the supply of money is increased, the price will go down. On the other hand if supply is restricted, the price will go up.

Imagine that the RBA has decided (as they did in May 2010) to increase the cash rate by 25 basis points (0.25%). To do this, they will need to reduce the availability of money in the market. In order to achieve this goal, the RBA will go through a series of steps:

1. Announcement: The first step is for the RBA to announce their intention to increase the cash rate. Since December 2007, this announcement has been made at 2.30pm on the the day of the monthly meeting of the RBA board.
   
2. Offer: After the announcement is made, the RBA will make an attractive offer in terms of the purchase or sale of second hand government securities. If they are trying to increase the cash rate, then they will offer to sell these securities in the financial market.  (Note: This is the key step in this process, and it is also the step most likely to appear as a question on the end of year exam.  Make sure you understand this point before moving on!)
   
3. Decision: When the securities are offered for sale, the price will be such that it is profitable for the banks to buy them. As a result, some of the banks will use funds in their Exchange Settlement Accounts (ESAs) to purchase securities from the RBA.
   
4. Initial Consequences: The law states that all ESAs must have a positive balance. As a result of the purchase of the second hand securities, some ESAs will have moved into an overdraft position. To overcome this problem, banks which have an overdrawn account will need to borrow from another Authorised Deposit-holding Institution (ADI), or from the RBA. As many ADIs will have purchased securities, very few will have money to lend; the RBA becomes the main net lender, and they will now lend at the higher rate.
   
5. Retail Level: The banks do not want to continue to borrow from the RBA every night, and so they must attract funds to "top up" their ESAs. There are two ways in which they can do this. First, they can encourage more people to save money in the accounts offered by the banks. To do this, they will need to increase the interest rate that they are offering. Alternatively, the bank can try to collect more money from the people who have borrowed from them. Once again, this requires an increase in interest rates. In this way the increase in interest rates has flowed through to the rest of the economy.

The reverse is true when the RBA wants interest rates to fall. This would occur when the opinion of the board is that inflation does not pose a threat in the short to medium term, and as such they can work to ensure that as many people as possible are employed, and the growth rate of the economy is satisfactory. To achieve this, the RBA will buy second hand government securities at an attractive rate, and therefore increase the funds that are available to banks in their ESAs. As the banks now have surplus funds, they will try to find a way to lend this money out to the general public in order to profit from it. Following the law of demand, as the price falls the quantity demanded will increase – as interest rates fall more people will take out loans. And so the banks will reduce the rate of interest for borrowers. Therefore more people will borrow money, and the consumption and investment components of aggregate demand will increase.

It is for this reason that the banks and non-bank financial institutions that make up the authorised deposit holding institutions in Australia are referred to as the Reserve Bank Information Transmission Service, or RITS. It is through the actions of the banks that the general public is affected by a change in the cash rate set by the RBA. In other words, it is the banks who transmit the information that the RBA is trying to convey.