The Federal Funds Rate

The Federal Reserve’s objective is to have sufficient money (loanable funds) in the banking system in order to achieve low levels of inflation, low interest rates, and a growing economy. Beginning in 1995, it began targeting the Federal Funds rate. The federal funds rate is the interest rate that banks charge each other on overnight loans. The Fed uses this rate as a barometer of what the Fed thinks is the proper amount of reserves in the banking system in order to achieve the optimal growth rate for the country. For more information about the Federal Funds rate, please click here.

Federal Reserve Tools to Affect the Money Supply

The Federal Reserve System attempts to change the Federal Funds rate by changing bank reserves, and, thus, our nation’s money supply. It does so by way of the following three tools.

1. Open Market Operations.
Open Market Operations is the most important and most frequently used of the three tools. Open Market Operations is the Fed’s activity of buying and selling U.S. Treasury and federal agency securities. Securities include bonds, notes, and bills. All three are “IOUs,” or proof that someone has lent money. These can be actual certificates or computer entries. The difference between the three securities is the maturity period (the number of years after which the lender agrees to pay back the loan). Bonds mature between 10 and 30 years; notes mature between 1 and 10 years; and bills mature within 1 year. Most of the time, the interest rate, which lenders receive, is higher on longer-term securities and bonds. This is because the longer maturity term carries a greater risk and a smaller chance that it will get paid back.

The United States Treasury, our federal (central) government’s financial manager, issues the securities to help finance federal deficits. The Federal Reserve Banks then trade these bonds in order to change the economy’s reserves (money supply). To put more money into circulation, the Fed buys securities from the public (see diagram below). Recently, the Fed has also purchased mortgage securities in order to prop up the financial markets as well as to affect the level of reserves. The public receives cash in exchange for the securities, which puts funds in circulation and increases the money supply. The reverse occurs when the Fed sells securities. This takes funds out of circulation and decreases the money supply. The ultimate effect of the transactions illustrated in the diagram is that the Fed “monetizes” the U.S. government (and recently also private) borrowing and, thus, increases the money supply.

Video Explanation
For a video explanation of open market operations, please visit:

 

2. Reserve Requirement Policy.

A bank’s reserve requirement is the percentage of deposited money that the bank is required to keep as cash. For most large banks, the reserve requirement on transactions accounts is 10 percent. This means that a bank must keep $10 in cash or in their account with their Fed bank out of every $100 deposited in cash. The rest it can loan out.

Banks with smaller amounts of funds in their transactions accounts are subject to a reserve requirement of either 0 or 3%. For the exact amounts, please click HERE. When the Federal Reserve decreases the reserve requirement, it allows banks to make more loans. This increases the money supply. Changing the reserve requirement is a drastic measure, which affects billions of dollars in reserves. Consequently, the Federal Reserve rarely changes the reserve requirement percentage.

 

3. Discount Rate and Federal Funds Rate Policy.

The discount rate is the interest rate that a commercial bank must pay the Federal Reserve Bank when the commercial bank borrows money from the Federal Reserve Bank. The more money a commercial bank borrows, the more it can loan out to its customers. This increases the money supply. Conversely, the money supply decreases when the Federal Reserve increases the discount rate and the commercial banks borrow less from the Fed banks. The Fed banks make three types of loans to commercial banks: short-term, long-term and seasonal. The rates on the short-term loans are the lowest, and the long-term rates are usually higher. The seasonal loans carry an average rate of selected market rates. For more information about the discount rate, please click HERE.

The Federal Funds rate is the interest rate commercial banks charge each other on overnight loans. The Federal Reserve attempts to influence this rate by supplying more or fewer funds to the banking system. If the Federal Reserve supplies more funds to the banking system, the Federal Funds rate decreases. This increases the money supply and may stimulate the economy in the short run. Conversely, if the Federal Reserve decreases funds to the banking system, the Federal Funds rate most likely increases. This decreases the money supply and slows down the economy in the short run.