Federal Funds Rate

Definition

The federal funds rate is the interest rate at which depository institutions (such as banks and credit unions) lend reserve balances to other depository institutions on an overnight basis. It is a key interest rate that influences the broader set of interest rates in the U.S. economy, including those for loans, mortgages, and savings accounts.

5 Must Know Facts For Your Next Test

1. The Federal Reserve sets the federal funds rate as a tool of monetary policy to influence economic activity, inflation, and employment.
2. Changes in the federal funds rate can have a ripple effect on other interest rates, such as those for mortgages, car loans, and business loans.
3. The federal funds rate is the interest rate at which banks lend to each other overnight to meet reserve requirements set by the Federal Reserve.
4. The federal funds rate is a key indicator of the overall level of short-term interest rates in the U.S. economy.
5. The federal funds rate is closely watched by financial markets and policymakers as a barometer of the health of the U.S. economy.

Review Questions

• Explain how the federal funds rate is related to the concept of interest rates discussed in Topic 3.4.
  • The federal funds rate is a key interest rate that directly influences the broader set of interest rates in the U.S. economy, as discussed in Topic 3.4. Changes in the federal funds rate, set by the Federal Reserve, can have a ripple effect on other interest rates for loans, mortgages, and savings accounts. As the federal funds rate rises or falls, it signals the overall direction of short-term interest rates, which are a fundamental component of the interest rate environment covered in Topic 3.4.
• Describe how the federal funds rate is considered a source of economic data, as discussed in Topic 3.6.
  • The federal funds rate is an important source of economic data, as discussed in Topic 3.6, because it provides valuable information about the overall health and direction of the U.S. economy. As a key interest rate set by the Federal Reserve, the federal funds rate is closely monitored by policymakers, economists, and financial markets as an indicator of economic conditions and the stance of monetary policy. Changes in the federal funds rate can signal the Federal Reserve's assessment of factors such as inflation, employment, and economic growth, making it a crucial data point for analyzing the state of the economy.
• Analyze how the federal funds rate is used as a tool of monetary policy to influence economic activity, as discussed in the related topics.
  • The federal funds rate is a primary tool of monetary policy used by the Federal Reserve to influence economic activity, as discussed in the related topics. By raising or lowering the federal funds rate, the central bank can tighten or loosen monetary policy to achieve its objectives of price stability, maximum employment, and sustainable economic growth. When the Federal Reserve increases the federal funds rate, it makes it more expensive for banks to borrow money, which can lead to higher interest rates for consumers and businesses, thereby slowing economic activity and controlling inflation. Conversely, a decrease in the federal funds rate can stimulate the economy by making borrowing cheaper and encouraging more spending and investment. The federal funds rate is a powerful lever that the Federal Reserve can use to steer the direction of the U.S. economy.

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 national economic goals.

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

Reserve Requirements: The amount of cash that banks must hold in reserve against deposits, which affects the ability of banks to lend and the money supply.