How Does the Federal Funds Rate Affect the Economy?

Federal Funds

Have you ever wondered how banks operate in the United States? What are the other factors that have an effect in the economy? In this article, you can read about the federal funds rate, how it affects the banking system and how it affects the whole economy.

The federal funds rate is being used by the Federal Reserve to manage the amount of money that banks can lend. The federal funds rate is said to be a key element in the operation of U.S. banks. It plainly means that banks must keep a minimum amount of funds around to cover funds withdrawals, or also known as reserve requirement.

Yet, this reserve requirement must be retained by the bank at the end of every business day. With the aim of meeting this requirement, sometimes, banks need to borrow money from other banks. To put it simply, the federal funds rate is the interest rate being charged by commercial banks to other banks from borrowing money overnight, which is typically the general rule.

How does the fed funds rate affect the economy?

Commonly, people know that the trade happening between banks has no effect on the economy, yet it is totally the opposite. If the fed funds rate set is high, banks will barely borrow money to meet the reserve requirement. If they do loan money at a higher rate, it then makes mortgages and loans costlier. This setting is termed by economists as contractionary monetary policy since an increase in rates makes other loans and mortgages costly. In turn, it leads to the contraction of the economy.

On the other hand, if the fed funds rate is lower, lending becomes affordable since banks are more likely to loan money from each other. Loans are out at cheaper rates. In turn, mortgages become cheaper and more people will purchase homes leading to businesses to borrow funds to grow their money. This setting is termed as expansionary monetary policy.


How is the fed funds rate set?

The fed funds rate is the weighted interest rate average that banks charge from one another. The Fed has no absolute control over this rate but it can somehow influence it.

Monthly, the Federal Open Market Committee (FOMC) – known as the Federal Reserve monetary policymaking body announces the Federal funds target rate. It is the rate the Fed requests banks to charge one another.

How are the fed funds affecting the investor?

The fed funds rate is the major tool used by the Fed to keep under control both inflation (expansion) and deflation (recession) in the economy. If the FOMC perceives that there is fast growth in the economy, they can act on it by raising the fed fund target rate to make lending slow down and impede inflation.

This set-up is advantageous and helpful to the investor. If investors would pay attention to the monthly FOMC remarks, they can somehow have an idea to where the economy is going.


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