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 overnight on an uncollateralized basis. It is a key interest rate in the United States economy, as it influences other short-term interest rates, economic activity, and inflation and employment.

5 Must Know Facts For Your Next Test

1. The Federal Reserve uses the federal funds rate as the primary tool to implement monetary policy and influence economic activity.
2. Adjustments to the federal funds rate can affect consumer and business borrowing, investment, and spending, which in turn impact aggregate demand and inflation.
3. A lower federal funds rate can stimulate the economy by making it cheaper for businesses and consumers to borrow and spend, while a higher rate can slow the economy by making borrowing more expensive.
4. The federal funds rate is a key determinant of the shape of the yield curve, which reflects the term structure of interest rates and can signal economic conditions.
5. The Federal Reserve closely monitors the federal funds rate and adjusts it in response to changes in economic indicators like employment, inflation, and GDP growth.

Review Questions

• Explain how the federal funds rate relates to the Macroeconomic Perspectives on Demand and Supply (Topic 11.1).
  • The federal funds rate is a key factor that influences aggregate demand in the economy. When the Federal Reserve lowers the federal funds rate, it becomes cheaper for businesses and consumers to borrow money, which can stimulate spending and investment, leading to an increase in aggregate demand. Conversely, when the Federal Reserve raises the federal funds rate, borrowing becomes more expensive, which can dampen aggregate demand. The federal funds rate, as a tool of monetary policy, can thus be used to manage the level of aggregate demand and help stabilize the economy.
• Describe how the federal funds rate relates to Keynes' Law and Say's Law in the AD/AS Model (Topic 11.6).
  • The federal funds rate is a crucial component in the Keynesian AD/AS model, where Keynes' Law (demand-driven) and Say's Law (supply-driven) interact. The federal funds rate, as a tool of monetary policy, can influence aggregate demand by affecting the cost of borrowing and the availability of credit. A lower federal funds rate can increase aggregate demand, while a higher rate can decrease it. This, in turn, can impact the equilibrium level of output and the price level in the AD/AS model, highlighting the importance of the federal funds rate in determining macroeconomic outcomes.
• Analyze the policy implications of the federal funds rate from the Neoclassical Perspective (Topic 13.2).
  • The Neoclassical perspective emphasizes the role of the federal funds rate in achieving full employment and price stability. From this view, the Federal Reserve can use the federal funds rate as a tool to influence aggregate demand and bring the economy to its natural level of output, where supply and demand are in equilibrium. By adjusting the federal funds rate, the central bank can affect interest rates, investment, and consumption, ultimately impacting the level of employment and inflation in the economy. The Neoclassical perspective thus highlights the importance of the federal funds rate as a key policy lever for the central bank to achieve its macroeconomic objectives.

Related terms

Monetary Policy: The actions taken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to promote economic growth and stability.

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

Reserve Requirements: The amount of funds that a depository institution must hold in reserve against specified deposit liabilities.