---
title: "Federal Funds Rate | Principles of Macroeconomics"
description: "Federal funds rate is the overnight rate banks charge each other for reserves, and in Principles of Macroeconomics it guides borrowing, spending, and inflation."
canonical: "https://fiveable.me/principles-macroeconomics/key-terms/federal-funds-rate"
type: "key-term"
subject: "Principles of Macroeconomics"
unit: "Unit 15"
---

# Federal Funds Rate | Principles of Macroeconomics

## Definition

The federal funds rate is the overnight interest rate banks charge each other for reserve balances. In Principles of Macroeconomics, it is the Fed’s main target for steering borrowing costs, spending, and inflation.

## What It Is

The federal funds rate is the overnight interest rate banks charge each other for reserve balances in the United States. In Principles of Macroeconomics, it is the main short-term rate the Federal Reserve tries to steer, so it sits at the center of monetary policy.

Here is the basic idea. Banks have to meet reserve requirements and manage how much cash they keep on hand. At the end of the day, one bank may have extra reserves while another comes up short, so they lend reserves to each other overnight. The rate on those loans is the federal funds rate.

The Federal Reserve does not usually set this rate by directly ordering banks to charge a specific number. Instead, it changes the supply of reserves in the banking system, mainly through open market operations. If the Fed adds reserves, the federal funds rate tends to fall. If it removes reserves, the rate tends to rise.

That is why this term shows up when you study expansionary and contractionary monetary policy. A lower federal funds rate usually makes borrowing cheaper for businesses and households, which can raise consumption and business investment. A higher rate usually makes borrowing more expensive, which can slow spending and cool inflation.

In macro graphs, the federal funds rate is the policy lever behind a lot of the movement in aggregate expenditure and aggregate demand. It does not change GDP by magic, it works through interest-sensitive spending. That includes car loans, mortgages, business loans, and other short-term financing decisions.

One common misconception is that the federal funds rate is the rate ordinary people borrow at directly. It is not. You usually see its effect filtering through other rates in the economy, such as rates on credit cards, auto loans, and business credit lines. Another helpful clue is that when the Fed announces a target range for the federal funds rate, it is signaling the direction of policy, not describing a random market price.

## Why It Matters

The federal funds rate is the quickest way to connect Federal Reserve policy to real macro outcomes. When you see a question about inflation, recession, or stimulus, this rate often sits in the middle of the chain from policy decision to household and business behavior.

It also gives you a clean way to explain cause and effect. If the Fed lowers the rate, banks can obtain reserves more cheaply, short-term borrowing costs often fall, and spending can rise. That can push aggregate demand up, which is why the term shows up in lessons on demand-side economics and monetary policy.

This term also helps you separate policy tools from policy goals. The Fed does not cut the federal funds rate just because it wants the number to look lower. It adjusts the rate to influence employment, inflation, and overall economic activity. That distinction matters when you are interpreting graphs, policy scenarios, or short written responses.

Finally, the federal funds rate is a bridge concept. It connects banking system mechanics, open market operations, and bigger models like AD/AS. If you can trace the rate through lending, investment, and demand, a lot of macroeconomics becomes much easier to read.

## Connections

### Monetary Policy

The federal funds rate is one of the main ways monetary policy reaches the wider economy. When the Fed wants to stimulate output, it lowers the rate; when it wants to slow inflation, it raises it. So if a question asks how the Fed responds to a recession or overheating, this rate is usually part of the explanation.

### [Open Market Operations](/principles-macroeconomics/key-terms/open-market-operations)

Open market operations are the Fed’s day-to-day tool for pushing the federal funds rate toward its target. Buying securities adds reserves to the banking system, which tends to lower the rate. Selling securities removes reserves, which tends to raise it. This is the mechanism, while the federal funds rate is the target outcome.

### [Aggregate Expenditure](/principles-macroeconomics/key-terms/aggregate-expenditure)

Changes in the federal funds rate affect borrowing costs, which then change consumption and investment spending. That makes it a useful link to aggregate expenditure, especially when you are explaining why total planned spending rises or falls after a policy move. The connection is strongest for rate-sensitive spending like homes, cars, and business expansion.

### [Business Investment](/principles-macroeconomics/key-terms/business-investment)

Businesses pay attention to interest rates when deciding whether to borrow for new equipment, buildings, or expansion. A lower federal funds rate can make those projects more attractive, while a higher rate can delay them. This is why investment spending often moves with monetary policy and why the Fed watches the business cycle so closely.

## On the AP Exam

A quiz item or problem set may ask you to trace what happens when the Fed raises or lowers the federal funds rate. Your job is to follow the chain, not just define the term. Start with the rate change, then explain how borrowing costs change, then connect that to spending, investment, aggregate demand, and inflation or output.

In a graph question, you may need to identify the policy direction from a recession or inflation scenario. If the economy is weak, a lower federal funds rate is expansionary. If prices are rising too quickly, a higher rate is contractionary. In a short essay, use the term to show how the Fed influences the economy through banks and short-term lending rather than through direct control of GDP.

## Key Takeaways

- The federal funds rate is the overnight rate banks charge each other for reserve balances, and it is the Fed’s main short-term policy target.
- The Fed changes this rate indirectly, mostly through open market operations that change the supply of reserves in the banking system.
- A lower federal funds rate usually encourages borrowing, spending, and business investment, which can raise aggregate demand.
- A higher federal funds rate usually slows borrowing and spending, which can help cool inflation.
- You usually see the effects of this rate show up in other interest rates, not just in bank-to-bank lending.

## FAQs

### What is the federal funds rate in Principles of Macroeconomics?

It is the overnight interest rate banks charge each other for reserve balances. In macroeconomics, it is the Fed’s main policy target for influencing borrowing costs, spending, and inflation.

### How does the Federal Reserve change the federal funds rate?

The Fed changes reserve conditions in the banking system, mainly through open market operations. Buying securities adds reserves and tends to lower the rate, while selling securities removes reserves and tends to raise it.

### Is the federal funds rate the same as the interest rate consumers pay?

No. Consumers do not usually borrow at the federal funds rate directly. Instead, that rate influences other rates, like mortgage rates, credit card rates, auto loans, and business loans.

### Why does a lower federal funds rate stimulate the economy?

Because it makes borrowing cheaper and can encourage households and firms to spend more. That extra spending can raise aggregate demand, which may increase output and employment in the short run.

## Related Study Guides

- [15.3 How a Central Bank Executes Monetary Policy](/principles-macroeconomics/unit-15/3-central-bank-executes-monetary-policy/study-guide/IQJ4TlJiDJme2k0k)
- [15.5 Pitfalls for Monetary Policy](/principles-macroeconomics/unit-15/5-pitfalls-monetary-policy/study-guide/QQjZm2mxBoRpOw4u)
- [13.2 The Policy Implications of the Neoclassical Perspective](/principles-macroeconomics/unit-13/2-policy-implications-neoclassical-perspective/study-guide/Y7dlZRh9cARGZRWU)
- [15.4 Monetary Policy and Economic Outcomes](/principles-macroeconomics/unit-15/4-monetary-policy-economic-outcomes/study-guide/aTixuqvgARNIDrIs)
- [11.6 Keynes’ Law and Say’s Law in the AD/AS Model](/principles-macroeconomics/unit-11/6-keynes-law-says-law-adas-model/study-guide/qIluWQAc5bb8lkSX)
- [15.1 The Federal Reserve Banking System and Central Banks](/principles-macroeconomics/unit-15/1-federal-reserve-banking-system-central-banks/study-guide/s4SMlHD9Jaywktpv)
- [11.1 Macroeconomic Perspectives on Demand and Supply](/principles-macroeconomics/unit-11/1-macroeconomic-perspectives-demand-supply/study-guide/x7aaYzHoahXOwfkO)

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