The monetary policy involves manipulating the interest rate on overnight loans in the money market. This is referred to as the cash rate. The cash rate impacts interest rates in the economy which influences the behaviour of borrowers and lenders, economic activity and inflation.
The Reserve Bank of Australia (RBA) is responsible for the Australian monetary policy. In determining the appropriate stance for the monetary policy, the reserve bank has a duty to maintain price stability, full employment, and economic prosperity and welfare of the Australian people. To correctly fulfill those duties, the reserve bank refers to the inflation target band of 2-3%. In doing so, the value of money is preserved and this encourages strong and sustainable growth in the economy over the long term.
The interest rate is also referred to as the rate (or cost) of borrowing money! When banks lend money, they expect to be repaid the amount which is referred to as the principal amount. Then they also charge the borrower a percentage of the principal amount to make some profit. Therefore, when interest rates are low, borrowers find it easier to repay debts and thus result in borrowing and spending more! When interest rates are high, borrowers therefore borrow less and spend less. The Reserve Bank cannot dictate what interest rates other banks must charge their customers, therefore they can manipulate the 'cash rate' or, how much money there is in the economy. Banks will lend large sums of money when there is more money in the economy. However, when there is a limited supply of money, it will cost consumers more to borrow. This is how the RBA can manipulate consumer spending in the economy!
Expansionary monetary policy increases the money supply in order to stimulate growth. As discussed earlier, an increase in money supply means interest rates are low which is an incentive for borrowers to borrow more and spend more in the society. When consumer spending is high, businesses grow and unemployment rates dwindle to satisfy the demands of the economy. As you may have already guessed, this expansionary monetary policy is to be used during times of high unemployment, low consumer spending, and low GDP growth.
On the other hand, the contractionary monetary policy is the exact opposite. Use this situation: The economy is booming at a rate which is too high and will cause inflation to exceed its threshold of 2-3%. Therefore the Reserve Bank must control and limit spending in the economy by decreasing the cash rate and increasing the interest rate. This will discourage borrowing and spending which will result in inflationary problems.
Another way in which the Reserve Bank of Australia can use to change the money supply in the economy is with federal reserves or securities which are bought and sold in an open market. Federal reserves can be sold to dealers in return for an amount which will increase money supply. They can also be sold to the RBA to reduce the money supply.