Bridging the textbook gaps on how the central banks implement monetary policy

Kellie Bellrose of RBA explains the difference between how textbooks explains central banks implementing monetary policy vs how central banks actually implements it.

Though the article is for Reserve Bank of Australia but applies to most central banks.

The RBA’s implementation of monetary policy is an area of confusion for professional economists, commentators and educators alike, particularly in reference to how closely the actual process aligns with the standard textbook explanations. T

he two main gaps in typical textbook explanations relate to:

    1. The omission of the policy interest rate corridor. The corridor is key to how the RBA implements monetary policy, particularly a change in monetary policy, as it encourages banks to trade ES balances at the target cash rate.
    2. The use of open market operations. Textbooks often link OMOs with achieving a change in the cash rate when, in practice, the RBA uses OMOs to manage the supply of cash to keep the cash rate at its target.

In summary, the market automatically trades at the new cash rate target following a change to monetary policy. This is achieved by the policy interest rate corridor, which resets around the new cash rate target, and banks have no incentive to trade outside of this corridor. Given the automatic adjustment to the cash rate target, there is no need for additional OMOs. OMOs are instead used by the RBA to manage the supply of cash (liquidity) in the market on a daily basis as part of its liquidity management practices.

This information can be viewed at a glance in the accompanying table ‘The Reality of Monetary Policy Implementation’.

Nice bit.

 

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