Economics Monetary Definitions

Overnight money market and Cash rate

The overnight money market (OMM) is the market for over night (1 day) loans largely between the banks.  The cash rate is the interest rate paid for these loans. The RBA manipulates the OMM to ensure that the cash rate is equal to the target cash rate by buying or selling Commonwealth Government Securities with the banks to increase or decrease liquidity (cash) in the market and so shift the supply curve for 1 day loans.

Exchange settlement account

Exchange settlement accounts (ESA) are accounts held by banks with the Reserve Bank of Australia.  They are used to settle payments between banks each day.  They are also where banks deposit money with, or lend money from, the RBA.  The RBA pushes the cash rate towards the target cash rate (TCR) by setting a deposit interest rate on the ESAs that is 0.25% below the TCR and a lending interest rate that os 0.25% above the TCR.  The banks have no incentive to borrow or lend money outside that band.

Target cash rate

The target cash rate is the Reserve Bank's target level for the cash rate.

Commonwealth government securities (CGS) / Australian government bonds

The Commonwealth government borrows money by issuing Commonwealth Government securities which include a promise to repay the loan and to pay interest.  The loan term can be as long as 30 years. These CGS can be sold on by the initial holder in the CGS market.

Liquidity

In relation to the overnight money market, liquidity means how much cash is available.  More liquidity means more cash.

Interest rate pass-through

When the Reserve Bank changes the target cash rate and thus the cash rate this will impact the economy to the extent that these changes are passed through to interest rates paid by businesses and consumers.

Lending margins

Banks' lending margins are the difference between the interest rates they pay when they borrow (from depositors and lenders in Australia and globally) and they interest rates they charge when they lend (for instance on housing loans and credit cards).

Transmission mechanism

Transmission mechanisms are the way in which changes to interest rates impact on economic activity.

Savings and investment channel

One transmission mechanism where for instance, interest rates on consumer and business loans decrease this encourages greater borrowing for consumption and investment Lower interest rates will also discourage saving which in turn boosts consumption as households choose to consume rather than save. These increases in consumption and investment will boost aggregate demand and thus economic activity.

Cashflow channel

One transmission mechanism When, for instance, interest rates on consumer and business loans decrease, businesses and consumers with existing variable rate loans will have lower interest payments on those loans.  This frees up cashflow, and increases discretionary income, for greater consumption by households.  It also frees up cashflow for businesses for greater investment or return of profit to households.  These increases in consumption and investment will boost aggregate demand and thus economic activity.  (Note although some households, those with no loans and high savings, are disadvantaged by lower interest rates, the overall effect is positive for aggregate demand).

Asset prices and wealth channel

One transmission mechanism is the asset prices and wealth channel.  When, for instance, interest rates on consumer and business loans decrease, the value of assets such as houses and shares tend to increase.  This is because cheaper credit increases demand for assets raising their prices.  Higher asset prices make consumers feel wealthier which tends to increase their level of consumption which will boost aggregate demand and thus economic activity.

Exchange rate channel

One transmission mechanism is the exchange rate channel.  When, for instance, interest rates decrease, the value of the Australian dollar is also likely to decrease.   This is because lower relative interest rates compared to other countries will reduce capital inflow of foreign funds due to the lower rates of return.  This will decrease demand for the Australian dollar putting downward pressure on the value of the dollar.  The lower exchange rate increases the competitiveness of the Australian tradeables sector and so increases net exports which will boost aggregate demand and thus economic activity.

Inflationary expectations

Inflation is also impacted by inflationary expectations.  For instance workers who expect high inflation will demand wage increases that more than cover their reduced purchasing power.  This in turn increases business costs causing business to raise prices to retain their profit.  If people have faith in the Reserve Bank to keep a check on inflation then inflationary expectations are less likely to take hold.

Monetary policy

Monetary policy is the making of decisions by the Reserve Bank which are designed to influence the cost, availability and demand for credit in order to influence aggregate demand and achieve the Reserve Bank's objectives of price stability, full employment and the economic welfare and prosperity of the Australian people.

Monetary policy setting/stance

The Reserve Bank will set monetary policy so that it neutral, expansionary or contractionary.  This is referred to as its monetary policy stance.

Neutral monetary policy

A neutral policy stance will be taken by the Reserve Bank when Australia is experiancing internal stability - a period of stable economic activity with sustainable rates of growth, full employment and low inflation.  A neutral stance is presently considered to be a target cash rate of around 3% but this can change over time and depends in part on the relationship between the cash rate and interest rates paid by consumers and businesses.

Expansionary monetary policy

The Reserve Bank is pursuing an expansionary monetary policy when the target cash rate is less than the neutral rate of 3%.  Such a policy is intended to stimulate the economy and encourage growth in aggregate demand and real GDP.

Contractionary/  restrictive monetary policy

The Reserve Bank is pursuing a contractionary monetary policy when the target cash rate is greater than the neutral rate of 3%.  Such a policy will tend to restrain the economy and discourage growth in aggregate demand and real GDP in order to reduce inflationary pressures.

Tightening (of monetary policy) / Less accommodative

A tightening of monetary policy occurs when the Reserve Bank raises the target cash rate.

Easing/loosening (of monetary policy) / More accommodative

A loosening of monetary policy occurs when the Reserve Bank lowers the target cash rate.

Leading indicators

Leading indicators are statistical measures that give policy makers advance warning of changes, for instance a significant increase in building approvals points to greater investment in construction in the coming year.

Lagging indicators

Lagging indicators are statistical measures that show changes in economic activity after this has occured (and so are not so useful for policy makers trying to anticipate economic conditions).  For instance an increasing unemployment rate is a lagging indicator of a slow down in real GDP growth.

RBA Charter

The Reserve Bank of Australia has three principal objectives.  The first is maintaining price stability which means an inflation rate of 2-3% measured by the CPI on average over time. The second is the maintenance of full employment. The final and overriding objective is the economic prosperity and welfare of the Australian people.

[Quantitative Easing]

In November 2020 during the Covid pandemic the Reserve Bank (RBA) had lowered the target cash rate to 0.10% which was as low as it could effectively be.  Because the RBA could not lower the TCR further it need to find other ways to boost aggregate demand.  One of these was quantitative easing (QE). QE means that the RBA boosts aggregate demand by buying assets (mostly Commonwealth Government Securities but also State and Territory bonds) from banks, insurance companies and others in the secondary market.  Buying bonds puts more cash into the economy which is then used for investment which boosts aggregate demand and pushes down the cost of funding. From Nov 2020 to Feb 2022 the RBA bought almost $300 billion of CGS and other bonds.