fed funds rate

Examples of fed funds rate in the following topics:

• Setting and Achieving the Interest Rate Target

  • Banks can seek to borrow from other banks holding funds at the Fed.
  • The rate that Fed member banks charge one another is referred to as the Federal Funds rate, or Fed Funds rate for short (rate for funds held at the Fed).
  • It is important to note that the Fed does not set the fed funds target rate, it only issues a range that it targets through active management of the money supply.
  • This in turn impacts the rate that Fed member banks are willing to charge each other for overnight loans, or the Fed Funds rate.
  • The fed funds rate will be within the range of the target; if not the Fed will adjust its open market operations (buying and selling of bonds) to achieve the range .

• The Discount Rate

  • The rate that member banks charge each other is the federal funds rate and the rate the Fed charges is referred to as the discount rate.
  • The interest rate is an active target and is set as a target rate range by the Fed; it is conveyed to the public by the Federal Reserve Open Market Committee (FOMC) as the fed funds target rate (short for the Federal Funds rate).
  • However, the rate that the central bank actually cares about is the fed funds rate.
  • The Fed targets the rate for federal funds via its open market operations and seeks to be the lender of last resort by charging banks a higher rate than the federal funds rate .
  • The discount rate is higher than the fed funds target rate and the variance serves as a disincentive for banks to seek funds or short-term borrowings from the Fed.

• Executing Expansionary Monetary Policy

  • The interest rate on the overnight borrowing of reserves is called the Federal Funds rate or simply the "fed funds rate."
  • For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.
  • At a lower fed funds rate, banks are more likely to increase loans, thereby expanding investment activity (in factories, for example, not financial instruments) and promoting economic growth.
  • Expansionary monetary policy will seek to reduce the fed funds target rate (a range).
  • Thus, the Fed's open market purchase increased the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) falls.

• The Federal Funds Rate

  • The Federal Funds rate (or fed funds rate) is the interest rate at which depository institutions (primarily banks) actively trade balances held at the Federal Reserve.
  • The Federal Funds rate is directly related to the interest rate paid by firms and individuals.
  • A high Federal Funds rate, therefore, has a contractionary effect on economic activity, while a low Federal Funds rate has an expansionary effect.
  • The Fed doesn't control the Federal Funds rate directly - it is negotiated between borrowing and lending banks - but it does set a target interest rate and uses open market operations in order to achieve that rate.
  • Influencing the Federal Funds rate is the primary monetary policy tool that the Fed uses to achieve its dual mandate of stable prices and low unemployment.

• Executing Restrictive Monetary Policy

  • The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate."
  • For example, if the supply of reserves in the fed funds market is lower than the demand, then the funds rate increases.
  • At higher fed funds rates, banks are more likely to limit borrowing and their provision of loanable funds, thereby decreasing access to loanable funds and reducing economic growth.
  • Restrictive monetary policy will seek to increase the fed funds target rate.
  • The Fed's open market purchase decreases the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) increases.

• Discount Policy

  • For example, a bank could borrow funds from the Fed at 2% and lend these funds out at 5%, earning 3% interest on the Fed loans.
  • For example, when the public and financial analysts see the federal funds interest rate fall, they infer the Fed is using expansionary policy.
  • On the other hand, if the federal funds rate rises, the public believes the Fed is using contractionary monetary policy.
  • As you know from this chapter, the Fed cannot control the federal funds rate, but can only influence it.
  • Other factors can cause the Federal Funds rate to rise or fall.

• Answers to Chapter 14 Questions

  • A lower discount rate is expansionary monetary policy because it could inject more funds into the banking system, expanding the money supply.
  • When the Fed conducts monetary policy, the policy affects the federal funds rate first.
  • If the federal funds rate rises, then the Fed may be pursuing contractionary monetary policy.
  • If the federal funds rate drops, subsequently, the Fed may be using expansionary monetary policy.
  • Monetary policy has an immediate impact on operating targets like the federal funds rates and non-borrowed reserves.

• Time Lags and Targets

  • Operating targets are the federal funds rate and non-borrowed reserves.
  • Federal funds rate is the interest rate that banks charge for lending their excess reserves to other banks.
  • When the Fed uses open-market operations, changes discount policy, or alters reserve requirement, the Fed's monetary policy has an immediate impact on the federal funds rate and non-borrowed reserves.
  • For example, the Fed selected interest rates as its intermediate target.
  • If the Fed wants to boost the interest rates, subsequently, the Fed must sell U.S. government securities.

• The Fed's Balance Sheet

  • Discount Loans are Federal Reserve loans funds to banks, helping the banks overcome short-term liquidity problems.
  • The Fed controls the interest rate on these loans, which influence the amount of loans that banks need.
  • We call the interest rate the discount rate.
  • Special Drawing Rights (SDRs): The International Monetary Fund (IMF) issues Special Drawing Rights that are credit securities.
  • Treasury pays expenditures, it transfers funds from its commercial bank accounts to its accounts at the Fed.

• Chapter Questions

  • What happens to bank reserves, interest rates, bond prices, and the money supply if the Fed bought U.S.
  • What happens to bank reserves, interest rates, bond prices, and the money supply if the Fed sold U.S.
  • Explain why the Fed concentrates on the growth rate of the money supply or short-term interest rates, but not both at the same time.
  • What happens to the short-term interest rates, bank reserves, and the money supply if the Fed changes the discount rate?
  • Why do the financial analysts and the public scrutinize the federal funds market?