In Australia, monetary policy is the responsibility of the Reserve Bank of Australia (RBA), and, according to the Bank, involves setting ‘the interest rate on overnight loans in the money market’. This interest rate is called the cash rate.

In many ‘advanced countries’ (as defined by the IMF) monetary policy is the responsibility of an independent central bank. This independence is designed to prevent monetary policy being used for ‘political purposes’ such as lowering interest rates in the months before an election, and to ensure that the government of the day cannot simply finance its spending by printing more currency.

The Board of the Reserve Bank is the legislated body responsible for monetary policy in Australia and is comprised of up to nine people – the Governor of the Reserve Bank, the Deputy Governor of the Reserve Bank, the Secretary of the Treasury, and six external members. The appointments of the Governor and the Deputy Governor are made by the Governor-General through the Federal Executive Council. The external members are selected by the Treasurer from a list of candidates maintained by the Governor of the Reserve Bank, and the Secretary of the Treasury. The use of a list was initiated by the Rudd government in December 2007. The Board meets 11 times a year, on the first Tuesday of every month other than January, and its decision is released at 2:30pm that day.

According to the legislation the RBA has three objectives: 1) the stability of the currency of Australia; 2) the maintenance of full employment in Australia; and 3) the economic prosperity and welfare of the people of Australia. Since the early 1990s the Bank, and most central banks in advanced countries, has attempted to satisfy these objectives by controlling inflation. Specifically, the Reserve Bank attempts to keep inflation between 2 and 3 per cent over the economic cycle (roughly seven or eight years). Other central banks have a more explicit target, for example the Bank of England attempts to keep inflation at 2 per cent.

The economic events which began in the second half of 2007 and are yet to be resolved, have resulted in some criticism of the focus of central banks on inflation. Critics have argued that central banks should have used monetary policy to control the housing bubble. Indeed some critics argue that the Federal Reserve System (the central banking system of the United States) was partially responsible for these events because the low federal funds rate (the United States equivalent of the Australian cash rate) between early 2002 and mid 2004 made it easier to borrow.

Central banks, and especially the US Federal Reserve System under Alan Greenspan, have traditionally been hesitant to try to burst market bubbles because of the difficulty in determining when markets are subject to a bubble, and the difficulty of bursting bubbles using monetary policy. However, the RBA would probably tighten monetary policy to burst an asset bubble even if it meant that expected inflation was below the target in the short-run. It seems likely that much research will focus on this area in the coming decade.

Further reading:
1) The RBA website – http://www.rba.gov.au/ – has a non-technical, though dense, overview of monetary policy – http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html – that is required reading in many 2nd year undergraduate macroeconomics courses. The RBA also produces a quarterly Statement on Monetary Policy – http://www.rba.gov.au/PublicationsAndResearch/StatementsOnMonetaryPolicy... – that summarises the current economic conditions, and in the final section provides the Bank’s GDP and inflation forecasts. Additional macroeconomic commentary is available in the Minutes of the Board meeting – http://www.rba.gov.au/MonetaryPolicy/RBABoardMinutes/2009/index.html – published a fortnight after the monetary policy decision is released. These generally only provide guidance as to the Bank’s interpretation of recent events rather than providing an explicit forecast.

2) Paul Krugman (who won the Nobel prize for economics in 2008) has been a prolific author of short-pieces for publications such as the New York Times, Slate, Foreign Affairs which do a great job of explaining economics without assuming a reader with an economics background, nor obviously advocating a particular partisan position A semi-famous piece that constructs a model of the economy from a group of babysitters – http://www.slate.com/id/1937 – is a painless introduction to thinking about macroeconomics and monetary policy. One slightly more difficult piece – http://web.mit.edu/krugman/www/MINIMAC.html – provides an economic education equivalent to some 2nd year undergraduate macroeconomics courses. An understanding of this material would allow you to hold your own when talking to most economists.