Federal funds rate

Definition

The federal funds rate is the interest rate at which banks lend reserves to each other overnight. It serves as a crucial tool for monetary policy, influencing overall economic activity by impacting other interest rates, investment, and consumer spending. Changes in the federal funds rate can affect inflation and employment levels, making it a key focus for central banks when aiming to achieve their economic goals.

5 Must Know Facts For Your Next Test

1. The federal funds rate is typically set by the Federal Open Market Committee (FOMC) and can change based on economic conditions.
2. Lowering the federal funds rate generally stimulates economic growth by making borrowing cheaper, while raising it can help control inflation by making loans more expensive.
3. The federal funds rate is a benchmark for various other interest rates, including those on mortgages, loans, and savings accounts.
4. Changes in the federal funds rate can impact stock prices, as lower rates tend to increase investment in equities while higher rates may lead to lower stock valuations.
5. The federal funds rate is often viewed as an indicator of the central bank's stance on monetary policy, with changes reflecting shifts in the economic outlook.

Review Questions

• How does the federal funds rate influence the broader economy through its impact on other interest rates?
  • The federal funds rate acts as a benchmark for other interest rates, affecting everything from mortgages to auto loans. When the Federal Reserve adjusts the federal funds rate, it influences borrowing costs for consumers and businesses alike. A lower federal funds rate typically leads to lower interest rates across the economy, encouraging spending and investment. Conversely, a higher rate can lead to increased borrowing costs, potentially slowing down economic activity.
• Analyze the relationship between the federal funds rate and inflation targeting in monetary policy.
  • The federal funds rate plays a critical role in inflation targeting as part of monetary policy. When inflation is above target levels, the Federal Reserve may increase the federal funds rate to cool off economic activity and reduce price pressures. On the other hand, if inflation is below target, lowering the rate can stimulate spending and investment, helping to push inflation back towards desired levels. This dynamic highlights how adjustments to the federal funds rate are essential for achieving stable prices in an economy.
• Evaluate how fluctuations in the federal funds rate can impact employment levels within the economy.
  • Fluctuations in the federal funds rate can have significant effects on employment levels through their influence on economic growth. When the rate is lowered, borrowing becomes cheaper for businesses, leading to increased investment and expansion, which can create jobs. Conversely, if the rate is raised too high, it can stifle business growth and result in layoffs or hiring freezes. Therefore, policymakers must carefully consider how changes to the federal funds rate will affect not just inflation but also employment as they strive for balanced economic growth.

Related terms

Open Market Operations: The buying and selling of government securities by the central bank to control the money supply and influence interest rates.

Discount Rate: The interest rate charged by central banks on loans to commercial banks, which can influence the overall federal funds rate.

Monetary Policy: The process by which a central bank manages the money supply and interest rates to achieve specific economic objectives.