Federal Funds Rate

Answer 1

the interest rate banks charge each other for overnight loans to meet their reserve requirements

Answer 2

Two of the chief duties of the Federal Reserve (colloquially known as the Fed) are to keep inflation under control and to keep the economy buzzing at a healthy level. This is a tall order that is not easily accomplished. Imagine a huge ocean liner trying to turn on a dime (a floating dime?). It’s a big ship full of complicated inter-related systems being acted upon by uncontrollable and, sometimes unknowable, forces. The same is true when you’re trying to steer the economy. It can be done to some extent, but it’s not an easy task. But how does the Fed do it? Well it has a number of strategies in its playbook, but perhaps the most commonly used one is to adjust the money supply. How can the Fed simply adjust the amount of money in circulation? The Fed essentially acts as a bank for banks. Every federal bank must hold reserves in an account with the Fed. And their reserves must meet certain guidelines set forth by the Fed that is in relation to the amount of money they have in demand deposit accounts. Since the amount of money in the customers’ bank accounts fluctuate daily, so does the bank’s balance with the Fed. Should the bank need more money in order to meet its reserve requirement at the end of each day it borrows money from another bank that has extra cash on hand. The short-term loan is usually done for the period of one day and is called a repurchase agreement, or repo for short. So, you may be wondering what interest rate the lending bank charges the borrowing bank. Well, this rate is set by the Fed and it is called the federal funds rate or the short term interest rate. By making adjustments to this interest rate the Fed essentially has control over the money supply. Albeit, this control is more like a ship captain’s turn at the helm of his ship, than a racecar drivers turn of his wheel. As the interest rate is lowered, banks may feel more like writing loans because they can use up their reserves and borrow to cover any shortfalls rather cheaply. These lower interest rates are passed along in the consumer and commercial loans written by the bank. As lower interest rates entice customers to borrow, businesses and households alike can fund projects they may have been putting off in a higher interest rate environment. This chain reaction of activity acts as a kick start to an ailing economy and as more loans get written there is more money in the economy. The reverse is true if the economy is too hot. The Fed may be concerned that unchecked growth could throw the inflation rate skyward. In this scenario they would tend to raise the interest rates. This is known as tightening the money supply. As the money supply constricts, economic growth is slowed. Businesses who may have been considering some capital expenditures will reconsider in a higher interest rate environment as they see their project’s hurdle rate rise. This constriction will slow the economy but it also puts inflation into check.