Australia’s official currency is the Australian Dollar (AUD), recognized globally for its stability and role in international trade. But beyond simply knowing what Australian money is called, understanding how it operates within the country’s monetary system is crucial. This article, brought to you by money-central.com, delves into the mechanisms the Reserve Bank of Australia (RBA) uses to manage the Australian Dollar and broader economic conditions.
The Reserve Bank of Australia employs a range of tools to implement monetary policy, ensuring the stability of the Australian Dollar and the Australian economy. While the most well-known tool is the cash rate target, the RBA also utilizes forward guidance, price and quantity targets for government bond purchases, and the provision of low-cost long-term funding to financial institutions. Let’s explore these tools and how they influence the Australian Dollar.
Understanding the Cash Rate Target and the Australian Money Market
The cash rate target is the primary instrument of monetary policy in Australia. To understand how it works, we need to examine five key aspects of the cash market: price, quantity, demand, supply, and the policy interest rate corridor.
The Price of Money: The Cash Rate
In the cash market, banks in Australia borrow and lend funds to each other overnight. The interest rate applied to these overnight loans is known as the cash rate. This cash rate is the ‘price’ of money in this interbank market. The Reserve Bank of Australia sets a target for this cash rate, making it a central tool for influencing broader interest rates and economic activity. Before the COVID-19 recession, the cash rate target was the RBA’s main, and practically only, active monetary policy tool impacting the Australian Dollar’s flow within the economy.
Quantity of Money: Exchange Settlement Balances
The volume of funds traded in this market is measured in Exchange Settlement (ES) balances. These balances are used by banks to settle transactions between themselves. Banks maintain accounts with the Reserve Bank to keep track of their ES balances. Because the Reserve Bank is the central bank of Australia and controls the supply of banknotes, ES balances are considered equivalent to cash, representing the digital form of Australian money for interbank operations.
Demand for Australian Dollars in the Cash Market
Banks require ES balances for two main reasons: as a store of value and to facilitate payments between each other. These payments can be on behalf of their customers or related to their own operational needs. The demand for ES balances isn’t static; it can fluctuate due to various factors, including changes in financial market conditions and the overall level of economic activity influencing the need for Australian Dollar transactions.
Supply of Australian Dollars and Open Market Operations
Before the COVID-19 recession, the Reserve Bank actively managed the supply of ES balances to align with estimated demand, ensuring the cash rate remained as close as possible to its target. This management was primarily achieved through open market operations, designed to counteract factors that could alter the supply of ES balances and thus the cash rate and the value of the Australian Dollar.
Specifically, the Reserve Bank frequently used repurchase agreements (repos) to manage ES balance supply. A repo involves two parts. First, the RBA could lend ES balances to a bank in exchange for a bond, effectively increasing the supply of ES balances available to banks and injecting liquidity into the market. This action can influence the cash rate and, consequently, the broader cost of borrowing in Australian Dollars. The second part of the repo is a pre-agreed reversal of the transaction, where the Reserve Bank returns the bond and receives the ES balances back, reducing the supply. This mechanism allowed the RBA to fine-tune the supply of ES balances, offsetting changes arising from other factors, such as government payments into or out of its Reserve Bank accounts, which also affect ES balance supply and the overall liquidity of Australian money markets.
However, the suite of policy measures introduced during the COVID-19 recession led to a significant surge in ES balances. As a result, the Reserve Bank no longer conducts daily open market operations to manage ES balances in the same way. The cash rate is now primarily maintained within the target range through the interest rate corridor system.
Policy Interest Rate Corridor and Managing the Cash Rate
The Reserve Bank currently implements a policy interest rate corridor to keep the cash rate aligned with its target. The RBA pays an interest rate on ES balances that is 0.1 percentage points below the cash rate target. This provides banks with a disincentive to hold excessive balances at this lower rate; they are encouraged to lend these funds out to earn the higher cash rate.
Conversely, the Reserve Bank also stands ready to lend ES balances to banks if needed, but at an interest rate 0.25 percentage points above the cash rate target. This acts as a ceiling, as banks are discouraged from borrowing at this higher rate and would prefer to borrow at the lower cash rate in the market if possible.
These deposit and lending rates set the lower and upper bounds of the policy interest rate corridor. Banks are incentivized to trade ES balances within this corridor. If market interest rates fell below the deposit rate offered by the Reserve Bank, banks would choose to hold more ES balances at the RBA. Conversely, if market rates rose above the lending rate, banks would borrow from the RBA at the cheaper rate. This corridor mechanism ensures that the cash rate remains close to the target set by the Reserve Bank, influencing the cost of borrowing and lending in Australian Dollars across the economy.
The corridor system also provides a framework for implementing changes to the cash rate target. Adjustments to the target are automatically reflected in the corridor’s bounds, shifting the incentives for trading within that range and effectively transmitting the desired monetary policy stance to the market and affecting the Australian Dollar’s value and availability.
In response to the COVID-19 recession, the Reserve Bank adopted other ‘unconventional’ monetary policy tools, such as the ‘Term Funding Facility’ and bond purchase program, which further increased the supply of ES balances. This shifted the supply curve in the cash market to the right, resulting in the cash rate sometimes trading near the floor of the corridor rather than precisely at the cash rate target.
Unconventional Monetary Policy Tools and Their Impact on the Australian Dollar
Since the COVID-19 recession, the Reserve Bank has actively utilized several unconventional monetary policy tools in addition to the cash rate target to further influence the Australian Dollar and the economy.
Forward Guidance: Shaping Expectations
Forward guidance involves public statements by the RBA about its future monetary policy intentions. The RBA’s forward guidance typically outlines the economic conditions the Board would need to see before considering an increase in the cash rate target. This guidance is ‘state-based,’ meaning it depends on the state of the economy. For example, in March 2020, the Board announced it would not raise the cash rate target until significant progress was made towards full employment and there was confidence that inflation would be sustainably within the 2-3 per cent target band. Recognizing public interest in the timing, the RBA also provided possible timeframes based on its forecasts, initially suggesting it would take at least three years to meet these conditions. Forward guidance aims to manage expectations about future interest rates, influencing borrowing costs and investment decisions in Australian Dollars.
Price and Quantity Targets for Asset Purchases: Injecting Liquidity
In 2020, the Reserve Bank introduced explicit price and quantity targets for its purchases of government bonds. These programs were designed to lower longer-term interest rates, reduce funding costs across the economy, and increase liquidity during the COVID-19 recession. The Reserve Bank purchased government bonds to:
- Support a target for the interest rate on three-year bonds (the yield target).
- Lower the yield on longer-term bonds beyond three years, below where they would otherwise be.
- Ensure the smooth functioning of the bond market.
The Reserve Bank purchased bonds issued by both the federal and state governments in exchange for ES balances, injecting further liquidity into the market and influencing interest rates across different maturities. Crucially, these purchases were made in the secondary market from the private sector, not directly from governments. These bond purchases aimed to directly influence the yield curve and lower borrowing costs in Australian Dollars.
Term Funding Facility: Providing Low-Cost Funding
Also in 2020, the Reserve Bank established a ‘Term Funding Facility’ (TFF) to reduce funding costs throughout the economy. The TFF provided banks and other financial institutions, such as credit unions and building societies, with access to low-cost, fixed-term funding. The TFF offered banks three-year loans at the cash rate target. As this rate was lower than typical funding costs, banks’ overall funding costs decreased, enabling them to offer lower interest rates on loans to households and businesses, stimulating economic activity in Australian Dollars. The TFF was launched in April 2020 and remained open for new borrowing until June 2021. All loans under the TFF will mature by June 2024.
For a deeper understanding of unconventional monetary policy, further resources are available, such as the Explainer: Unconventional Monetary Policy.
The Future of Monetary Policy Implementation for the Australian Dollar
Looking ahead, in March 2024, the Reserve Bank Board endorsed a plan to transition to a new system for implementing monetary policy known as ‘ample reserves’. Further details on this new system will be provided in due course.[1] This evolution reflects the ongoing adaptation of monetary policy tools to effectively manage the Australian Dollar and the Australian economy in a changing global landscape.
In conclusion, while the answer to “What Is Australian Money Called?” is simply the Australian Dollar, the mechanisms that govern its value and stability are complex and multifaceted. The Reserve Bank of Australia utilizes a range of tools, from the traditional cash rate target to unconventional measures, to ensure the smooth functioning of the Australian economy and maintain confidence in the Australian Dollar.
