Federal funds rate

Definition

The federal funds rate is the interest rate at which banks lend reserve balances to other depository institutions overnight. This rate is a key tool used by the Federal Reserve to influence monetary policy, affecting the economy by impacting borrowing costs, consumer spending, and investment decisions.

5 Must Know Facts For Your Next Test

1. Changes in the federal funds rate can directly influence other interest rates, including those for mortgages, loans, and savings accounts.
2. The federal funds rate is determined by the Federal Open Market Committee (FOMC) during its scheduled meetings, reflecting economic conditions and forecasts.
3. A lower federal funds rate typically encourages borrowing and spending, stimulating economic growth, while a higher rate can help curb inflation by making borrowing more expensive.
4. Historically, significant changes in the federal funds rate have often preceded major shifts in economic activity, making it a critical indicator for economists and policymakers.
5. The federal funds rate is closely watched by financial markets; any unexpected changes can lead to volatility in stock prices and investor sentiment.

Review Questions

• How does the federal funds rate impact overall economic activity?
  • The federal funds rate influences overall economic activity by affecting borrowing costs for banks. When the rate is low, banks can borrow more cheaply, which encourages them to lend more to consumers and businesses. This increased lending can lead to higher consumer spending and business investment, stimulating economic growth. Conversely, a higher federal funds rate raises borrowing costs, which can dampen spending and slow down economic activity.
• Evaluate how changes in the federal funds rate might affect monetary policy decisions made by the President and Congress.
  • Changes in the federal funds rate can have significant implications for monetary policy decisions made by both the President and Congress. For example, if the Federal Reserve raises the rate to combat inflation, this may prompt concerns from lawmakers about slowing economic growth. The President might advocate for fiscal policies that complement these monetary policies, such as increased government spending or tax cuts, to stimulate demand. Thus, shifts in the federal funds rate create a dynamic interplay between monetary policy set by the Fed and fiscal policies enacted by elected officials.
• Analyze the potential long-term consequences of maintaining a persistently low federal funds rate on the economy.
  • Maintaining a persistently low federal funds rate can lead to several long-term consequences for the economy. While it may promote immediate borrowing and spending, it can also result in asset bubbles as investors seek higher returns in riskier assets due to low yields on safer investments. Additionally, prolonged low rates can diminish banks' profitability, leading to tighter lending standards that could stifle economic growth in the future. Moreover, if inflation rises unexpectedly after a long period of low rates, it may force the Federal Reserve to enact abrupt increases in rates, potentially destabilizing markets and leading to recession.

Related terms

Monetary Policy: The process by which the central bank manages the money supply and interest rates to achieve macroeconomic objectives like controlling inflation and fostering economic growth.

Open Market Operations: The buying and selling of government securities in the open market by the Federal Reserve to regulate the money supply and influence interest rates.

Discount Rate: The interest rate charged by central banks on loans to commercial banks or other financial institutions, which serves as a benchmark for other interest rates in the economy.