Fed Funds Rate

This tutorial provides an in-depth view into the fed funds rate.  The speaker goes into discussing what a depository institution is, reserve requirements, reserve balances, target & effective fed funds rate, and talks about fed funds rate as a tool of fighting inflation and setting monetary policy.

A depositary institution can accept deposits from customers which, in turn, it can lend out to other customers to make interest income.  However, they cannot lend out the entire deposit amount; they must keep in reserves.  This reserve percentage is mandated by the federal reserve.  As of Sept 2008, there is a 3% reserve requirement on balances between 9.3 million to 43.9 million dollars.  For amounts above 43.9 million, a 10% reserve requirement is required by the bank. 

These reserve balance do not earn interest; however, banks with excess reserves can lend out their excess reserves for an interest rate.  This interest rate is referred to as the fed funds rate and does not require the borrowing bank to have collateral.  The fed cannot control the interest rate that the banks charge each other but set a target rate to suggest a rate that they would prefer banks lending to each other.  The Fed attempts to control this through open market operations by buying or selling treasury securities to influence the available money supply

He goes on to suggest that the fed funds rate is a very important tool in managing the US economy.  It is an effective tool for managing unemployment and fighting inflation.  To decrease the unemployment rate, the fed will reduce to fed funds rate which will trickle down to the banks reducing their interest rates which in turn helps out the consumer.  Lower costs to borrow will spur spending and increase demand for goods and services. 

Conversely, to fight inflation, the fed will increase the fed funds rate which will increase bank lending rates which discourages consumers and business from borrowing and spending.  This puts downward pressure on prices and is supposed to decrease inflationary pressures.

 


Tim Ord
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