Perhaps the most frequently reported detail of Fed policy is the target set for
ID: 1199746 • Letter: P
Question
Perhaps the most frequently reported detail of Fed policy is the target set for the federal funds rate. Although this isn’t a tool of the Fed, it is a good goal for the Fed to work toward because it’s easy to observe and conveys good information about the state of the economy.
Explain what the federal funds rate is. (3 points)
Would an increase in the federal funds rate be expansionary or contractionary? (2 points)
What might the Fed do if the federal funds rate is higher than the target rate? How would it use its tools to achieve this target? (3 points)
Explanation / Answer
1. The Federal funds rate in the United States is the rate at which the depository institutions, usually banks and credit unions, lend reserve balances to other depository institutions overnight, without any collateral basis. It is generally applicable to the most creditworthy institutions when they borrow and lend overnight funds to each other.
2. The increase in the Federal funds rate would discourage banks from borrowing to meet reserve requirements, which encourages them to build up reserves and lend out less money. It is contractionary in nature. When a bank is unable to meet the reserve requirements it may borrow from the Fed funds, these are unsecured loans and generally for very short periods, (overnight).
3. A lower funds rate implies expansionary monetary policy by the Fed. It is a low interest rate environment for businesses and consumers, and relatively high level of inflation. Lower interest rates normally stimulates aggregate demand and employment. The current Funds Rate is targeted between 0.25% and 0.5%. The Federal Open Market Committee (FOMC) last raised the funds rate December 16, 2015.
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