Federal funds rate

Definition

The federal funds rate is the interest rate at which banks lend reserves to each other overnight. This rate is a critical benchmark for other interest rates and influences the overall cost of borrowing in the economy, playing a significant role in monetary policy and economic activity.

5 Must Know Facts For Your Next Test

1. The federal funds rate is set by the Federal Open Market Committee (FOMC) and can change in response to economic conditions.
2. Changes in the federal funds rate directly affect other interest rates, such as those for mortgages and savings accounts.
3. A lower federal funds rate typically encourages borrowing and spending, which can stimulate economic growth.
4. Conversely, a higher federal funds rate can help control inflation by making borrowing more expensive and encouraging saving.
5. The federal funds rate is an important indicator of the overall health of the economy and is closely monitored by investors and policymakers.

Review Questions

• How does the federal funds rate impact other interest rates in the economy?
  • The federal funds rate serves as a benchmark for various other interest rates, including those for loans, mortgages, and savings accounts. When the Federal Reserve adjusts this rate, it influences the cost of borrowing across the economy. For instance, if the federal funds rate decreases, banks can borrow money at a lower cost and may pass those savings onto consumers in the form of lower loan rates, thus encouraging spending and investment.
• Discuss the role of the federal funds rate in monetary policy and its implications for economic stability.
  • The federal funds rate is a key tool in monetary policy, used by central banks to influence economic activity. By adjusting this rate, the Federal Reserve can either stimulate the economy by lowering rates or cool it down by raising them. These changes have significant implications for inflation control, employment levels, and overall economic stability, making it vital for policymakers to carefully monitor economic indicators when deciding on adjustments.
• Evaluate how changes in the federal funds rate can affect investment decisions made by corporations.
  • Changes in the federal funds rate can significantly influence corporate investment decisions. A decrease in this rate typically lowers borrowing costs for businesses, making it more attractive to finance new projects or expand operations. Conversely, if the rate rises, companies may delay or reduce their investment plans due to higher costs associated with financing. This relationship between the federal funds rate and corporate investment is crucial for understanding broader economic trends and potential growth opportunities.

Related terms

Discount Rate: The interest rate charged by central banks to commercial banks for short-term loans.

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

Monetary Policy: The actions undertaken by a central bank to control the money supply and achieve macroeconomic goals such as controlling inflation, consumption, growth, and liquidity.