RDP 9008: Financial Deregulation and the Monetary Transmission Mechanism 2. Policy and Institutional Background

Up until the early 1980s the Australian financial system was heavily regulated and monetary policy operated mainly through a panoply of direct controls. The major instruments were the use of ceilings on the growth of bank lending, restrictions on deposit and lending rates, and the use of the Statutory Reserve Deposit (SRD) arrangement in conjunction with the Liquid Assets and Commonwealth Government Securities (LGS) convention. In addition, exchange rates were set by the authorities and international capital movements were subject to a number of controls. Under the SRD arrangement, trading banks were required to hold a certain percentage of their total Australian deposit base with the Reserve Bank. The LGS convention was an agreement between the Reserve Bank and the trading banks whereby the trading banks agreed to maintain a certain proportion of their deposits as liquid assets, mainly Commonwealth Government securities.

A tightening of monetary policy during this period was implemented by a number of quantitative measures e.g., changes in the SRD ratio, or imposing ceilings on bank lending. Alternatively, open market operations were used to sell government securities. Because banks' deposit rates were controlled, the sale of securities to the non-bank public reduced the liquidity of banks and thus restricted their ability to lend by attracting funds out of their deposit base. Bank credit was thus rationed, with lending rates unable to increase to clear the market. However, the effectiveness of this set of policies gradually became eroded as the excess demand for credit was diverted to other financial institutions which were not subject to the controls faced by banks. These non-bank financial institutions generally charged higher interest rates than banks and so, to an certain extent, a quasi-price rationing of credit took place.

Since the floating of the Australian dollar in December 1983, the Reserve Bank has used interest rates as the operating instrument of monetary policy. The Bank uses open market operations to buy or sell securities to a specific group of financial institutions, viz., the authorised money market dealers. Their main function is to manage banks' exchange settlement funds. If the Reserve Bank seeks to tighten monetary conditions, it sells securities to these dealers who finance their purchases by bidding for funds from other financial institutions. This leads to an increase in cash rates, and subsequently to increases in other interest rates, such as the 90 day bank bill rate.^[3]

A critical feature of the new arrangements is that since the banking system must settle with the central bank in “cash”, there will always be a demand for central bank liquid assets. Thus the monetary authorities can exert influence over short term interest rates and affect the real economy directly through the interest sensitive components of aggregate demand. The question remains open, however, whether monetary policy affects the real economy any differently, in a reduced form sense, under deregulation. One possibility is that, since monetary policy now affects the entire financial system, its effects on the real economy are enhanced. Another possibility, however, is that the only effect of deregulation is to increase the amount of intermediation done by banks at the expense of non-bank financial institutions. This certainly distorts some of the monetary aggregates, rendering them inoperable as intermediate targets of monetary policy. It does not, however, necessarily change the relationship between the amount of credit extended by the financial system as a whole and the real economy.

Footnote

For a more detailed explanation of Reserve Bank operations, see Grenville (1990) or Carmichael (1990). [3]