Chapter 6 The Monetary System

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The Federal Funds Rate

If one bank is short of reserves while another bank has excess reserves, the second bank can lend reserves to the first bank. 

The loans are short term, typically overnight, called overnight loans. The price of the loan is the federal funds rate. And the lending or borrowing among bankers form the federal funds market. Federal funds refers to the amount of reserves in banking system which can be borrowed or loaned out by commercial banks.

The discount rate is the interest rate banks pay to borrow from the Fed through discount window. Borrowing from other banks in the federal funds market is an alternative to borrowing. Banks will typically borrow from whichever is cheaper. In practice, the discount rate and the federal funds rate move colsely together.

When the federal funds rate rises or falls, other short-term interest rates often move together. Thus, the federal funds rate is considered a barometer of other short-term interest rates.

In recent years, the Fed has set a target for the federal funds rate.

The actual federal funds rate(FFR) is determined by the supply and demand in the market for loans among banks.

While, in order to make the federal funds rate hit the target, the Fed can use open market operations to influence the federal funds market.

The demand for federal funds comes from banks that find themselves with insufficient reserves, perhaps because they made too many loans or had higher-than-expected withdrawals.  

The supply of federal funds comes from banks that find themselves with more reserves than they want, perhaps because they had lower-than-expected withdrawals or because few customers took out loans. 

The federal funds rate adjusts to balance the supply of and demand for federal funds.  

(1) If the rate rises above the Fed's target, the Fed buys govt bonds in the open market, injecting reserves into the banking system, increasing the supply of money can be lend among banks and pushing the rate down.  

Therefore, open market purchase would decrease the federal funds rate.

(2) If the actual federal funds rate starts to fall below the Fed’s target, the Fed sells government bonds in the open market in order to pull reserves out of the banking system. Thus, the supply of federal funds decreases, resulting in an increase on the federal funds rate.

Therefore, open market sale can increase the federal funds rate.