Federal Funds Rate

Definition

The federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions on an overnight basis. It is a key interest rate that affects the broader economy and is a primary tool used by the Federal Reserve to influence monetary policy and economic conditions.

5 Must Know Facts For Your Next Test

1. The Federal Reserve uses the federal funds rate as its primary tool to influence monetary policy and economic conditions.
2. Adjusting the federal funds rate affects other short-term interest rates, which in turn impacts consumer and business borrowing, spending, and investment.
3. When the Federal Reserve wants to stimulate the economy, it will lower the federal funds rate to encourage borrowing and spending.
4. Conversely, the Federal Reserve will raise the federal funds rate to slow down an overheating economy and curb inflation.
5. The Federal Open Market Committee (FOMC) is responsible for setting the federal funds rate target at its regular meetings.

Review Questions

• Explain the role of the federal funds rate in the Federal Reserve's monetary policy toolkit.
  • The federal funds rate is a key interest rate that the Federal Reserve uses as its primary tool to implement monetary policy. By raising or lowering the federal funds rate, the Fed can influence other short-term interest rates, which in turn affects consumer and business borrowing, spending, and investment. When the economy is sluggish, the Fed will lower the federal funds rate to stimulate borrowing and spending. Conversely, the Fed will raise the federal funds rate to slow down an overheating economy and curb inflation.
• Describe how changes in the federal funds rate can impact the broader economy.
  • Adjustments to the federal funds rate by the Federal Reserve have far-reaching effects on the economy. When the Fed lowers the federal funds rate, it becomes cheaper for banks to borrow money, which incentivizes them to lend more to consumers and businesses. This increased lending and borrowing activity can stimulate economic growth, as consumers have more access to credit for big-ticket purchases like homes and cars, and businesses can more easily obtain financing for investments. Conversely, when the Fed raises the federal funds rate, it becomes more expensive for banks to borrow, leading to higher interest rates on loans, which can slow down consumer spending and business investment, potentially cooling an overheating economy.
• Analyze how the Federal Open Market Committee's (FOMC) decisions regarding the federal funds rate target are influenced by economic conditions and the Fed's dual mandate of price stability and maximum employment.
  • The FOMC, which is responsible for setting the federal funds rate target, carefully considers the state of the economy and the Fed's dual mandate of price stability and maximum employment when making its decisions. If the economy is growing too quickly and inflation is rising, the FOMC will likely raise the federal funds rate to slow down economic activity and bring inflation under control. Conversely, if the economy is sluggish and unemployment is high, the FOMC may lower the federal funds rate to stimulate borrowing, spending, and investment, with the goal of promoting full employment and stable prices. The FOMC's federal funds rate decisions are thus a delicate balancing act, as it seeks to achieve the optimal level of economic growth and employment while maintaining price stability.

Related terms

Monetary Policy: The actions taken by a central bank, such as the Federal Reserve, to influence the money supply and interest rates in order to achieve economic goals like price stability, full employment, and economic growth.

Open Market Operations: The buying and selling of government securities by the Federal Reserve to influence the money supply and interest rates, including the federal funds rate.

Reserve Requirements: The amount of cash that banks must hold in reserve against deposits, which the Federal Reserve can adjust to affect the money supply and federal funds rate.