Federal Funds Rate

Definition

The federal funds rate is the interest rate at which depository institutions (such as banks) lend reserve balances to other depository institutions overnight on an uncollateralized basis. It is a key monetary policy tool used by the Federal Reserve to influence the overall level of interest rates and economic activity.

5 Must Know Facts For Your Next Test

1. The Federal Reserve uses the federal funds rate as its primary monetary policy tool to influence the overall level of interest rates and economic activity in the United States.
2. Lowering the federal funds rate is an expansionary monetary policy that aims to stimulate the economy by making it cheaper for businesses and consumers to borrow money.
3. Raising the federal funds rate is a contractionary monetary policy that aims to slow down the economy and control inflation by making it more expensive for businesses and consumers to borrow money.
4. Changes in the federal funds rate can lead to shifts in aggregate demand, as they affect the cost of borrowing and the availability of credit in the economy.
5. The Federal Reserve closely monitors economic indicators like inflation, unemployment, and GDP growth when deciding whether to adjust the federal funds rate as part of its monetary policy.

Review Questions

• Explain how the federal funds rate is related to shifts in aggregate demand.
  • The federal funds rate is a key determinant of the overall level of interest rates in the economy. When the Federal Reserve lowers the federal funds rate, it becomes cheaper for businesses and consumers to borrow money, which can lead to an increase in spending and investment. This shift in aggregate demand can stimulate economic growth. Conversely, when the Federal Reserve raises the federal funds rate, it becomes more expensive to borrow, potentially leading to a decrease in spending and investment, and a shift in aggregate demand.
• Describe how the Federal Reserve uses the federal funds rate to execute monetary policy.
  • The Federal Reserve uses the federal funds rate as its primary tool to implement monetary policy. By adjusting the federal funds rate, the central bank can influence the overall level of interest rates in the economy. Lowering the federal funds rate is an expansionary monetary policy that aims to stimulate the economy, while raising the federal funds rate is a contractionary policy intended to slow down the economy and control inflation. The Federal Reserve closely monitors economic indicators and uses open market operations to adjust the federal funds rate and achieve its policy objectives.
• Analyze the potential pitfalls the Federal Reserve may face when using the federal funds rate to conduct monetary policy.
  • One potential pitfall is that changes in the federal funds rate may have unintended consequences on the economy. For example, raising the federal funds rate to combat inflation may also slow economic growth and lead to higher unemployment, which could create a tradeoff between the Federal Reserve's dual mandate of price stability and full employment. Additionally, the federal funds rate may not be as effective in stimulating the economy during times of financial crisis or when interest rates are already near zero, known as the zero lower bound. In such cases, the Federal Reserve may need to rely on unconventional monetary policy tools, which can be more difficult to implement and communicate effectively to the public.

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 stable prices, 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, which is the primary tool used to implement monetary policy.

Reserve Requirements: The amount of cash that banks must hold in reserve against deposits, which the Federal Reserve can adjust to influence the money supply and interest rates.