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 overall economy by controlling money supply and influencing other interest rates.

5 Must Know Facts For Your Next Test

1. The federal funds rate is set by the Federal Open Market Committee (FOMC) and can be adjusted multiple times throughout the year based on economic conditions.
2. Changes in the federal funds rate influence borrowing costs for consumers and businesses, thereby affecting spending and investment in the economy.
3. A lower federal funds rate generally encourages economic growth by making loans cheaper, while a higher rate can help to curb inflation.
4. The federal funds rate impacts various financial instruments, including mortgages, loans, and savings rates, thereby influencing consumer behavior.
5. Market participants closely monitor changes in the federal funds rate as an indicator of future economic trends and Federal Reserve policy intentions.

Review Questions

• How does the federal funds rate influence the broader economy?
  • The federal funds rate influences the broader economy by affecting borrowing costs for banks, which in turn impacts lending rates for consumers and businesses. When the Federal Reserve adjusts this rate, it changes the cost of money in the economy. A lower rate typically encourages spending and investment, stimulating economic growth, while a higher rate can lead to reduced spending and slower economic activity.
• Discuss the relationship between the federal funds rate and inflation control.
  • The federal funds rate plays a crucial role in controlling inflation. When inflation rates rise above target levels, the Federal Reserve may increase the federal funds rate to make borrowing more expensive. This discourages spending and investment, helping to slow down the economy and reduce inflationary pressures. Conversely, if inflation is low, lowering the rate can encourage economic activity and spending to boost inflation toward desired levels.
• Evaluate how changes in the federal funds rate can affect market expectations and investor behavior.
  • Changes in the federal funds rate significantly affect market expectations and investor behavior. When investors anticipate a rise or fall in this rate, they adjust their investment strategies accordingly. For instance, if they expect rates to rise, they might shift towards fixed-income securities that benefit from higher yields. Alternatively, if rates are expected to drop, investors might flock to stocks as cheaper borrowing costs can spur corporate growth. Such adjustments highlight how closely tied financial markets are to monetary policy decisions made by the Federal Reserve.

Related terms

Monetary Policy: The process by which a central bank, like the Federal Reserve, manages the money supply to achieve specific goals such as controlling inflation and promoting economic growth.

Interest Rate: The amount charged by lenders to borrowers for the use of money, expressed as a percentage of the principal.

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