Implementation of monetary policy
The RBA implements monetary policy primarily via the manipulation of interest rates. Whilst the RBA has no direct control over all interest rates in the economy, its ability to directly manipulate the 'cash rate' enables it to indirectly affect all other interest rates.
The cash rate is the interest rate that applies to borrowing and lending in the overnight money market (also called 'cash market'). The RBA directly manipulates the supply of cash in the cash market by buying and selling Commonwealth Government Securities (CGS) or repurchase agreements (repos) to participants in the cash market (e.g. banks). This manipulation of the cash market is commonly referred to as open market operations (OMOs)
If liquidity in the cash market has fallen (i.e. the market is short of cash) and the RBA wished to prevent a rise in the cash rate, it would increase liquidity in the market by buying CGS or repos. This places downward pressure on the cash rate and can be depicted by a standard demand/supply diagram to the right.
[The RBA directly manipulates the supply of cash in the cash market via its control over exchange settlement accounts (ESAs), which are accounts held by all the commercial banks with the RBA. These accounts are set up to facilitate the transfer of funds between banks after settling amounts owing following interbank transactions. However, an understanding of the importance of these accounts is not crucial to the development of a solid understanding of how the RBA manipulates the cash market.]
The injection of liquidity in the market increases the supply of cash and pushes the S curve from S1 to S2. This creates an excess supply of cash in the market, forcing the cash rate down towards the desired level (CR2). Note that liquidity increases in the market because cash market participants received cash in exchange for the CGS or repos. The cash can now be lent to other market participants, thereby increasing the supply of cash in the market.
If liquidity in the cash market has increased (i.e. the supply of cash is higher) and the RBA wished to prevent a fall in the cash rate, it would decrease 'liquidity' in the market by selling CGS or repos. This places upward pressure on the cash rate. Note that liquidity decreases in the market because cash market participants received CGS or repos in exchange for the cash. Again, intervention can be depicted by the shift to the left of the supply curve in the cash market, creating excess demand for cash and forcing the cash rate towards CR2.
The role of the target cash rate
The RBA sets a target cash rate that is consistent with monetary policy settings as determined at the RBA's monthly Board meetings. Once the target is set, the RBA will operate in the cash market on a daily basis via OMOs to ensure that the actual cash rate is as close as possible to the target cash rate. The actual cash rate will always be hovering very close to the target and every morning the RBA will determine whether it has to increase liquidity (if the actual cash rate is above the target) or decrease liquidity (if the actual cash rate is below the target).