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Federal Funds Market

Federal Funds Market

Author: Kate Eskra

Identify how the fed funds target rate is used to manage the money supply.

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on the Federal funds market. As always, my key terms are in red and my examples are in green.

So in this tutorial, we'll identify the tools that the Fed has to manage our nation's money supply. You'll understand what the Federal funds rate is and when and why banks need to pay it. And we'll talk about what the Fed will do to this Fed funds target rate when they want to expand or contract the economy.

So the FOMC, or Federal Open Market Committee, is the part of our Federal Reserve System that meets several times a year to manage our nation's money supply. And they have four basic tools to control our money supply. And they are the reserve requirement, the amount of money that banks have to keep on hand; open market operations, or the buying and selling of US Treasuries; the Federal funds market; and the discount rate. Obviously, this tutorial is on the Fed funds market.

So we know that we have a fractional reserve system in our country. And that is because of how banks make money. If they just stored it, they wouldn't profit at all.

So the idea here is when we deposit money into a checking account in a bank, we can actually demand that at any time, right? We can write a check on it. We can swipe our debit card on it. Because of that, checking accounts are sometimes called demand deposits.

But banks are going to make money by lending out at least a portion of what we've deposited and then charging interest on those loans. So this fractional reserve system, the idea that they can loan out a portion of our deposits, allows for the creation of money in our economy. And it works well most the time.

The problem only becomes if banks end up lending out way too much money, or if for some reason people show up demanding a lot more cash than normal, a lot more cash than is available on hand at the banks. When that's the case, the bank can't meet their demands. And this actually used to happen a lot before our Fed was created. And banks would then fail or go bankrupt.

And that was not good for our overall economy. When people heard of banks failing or going bankrupt, then bank runs would be common. Bank panics, a panic situation, was when a lot of people would run and do this in mass, basically, to all of the banks, because their confidence was very low that banks would have enough money to meet their demands.

So because this became such a major problem, the Fed now today regulates how much of these reserves the banks actually have to hold onto. Banks either hold their reserves in their vaults at the actual bank or at the regional Fed bank. And the Fed regulates this by setting a reserve requirement, usually expressed as a percentage, so 10%, for example.

So if a bank it can't meet their reserve requirement for the day, if for some reason more people came demanding their money, then that bank actually is not permitted to close until they've met their reserve requirement. They would have to get their hands on more money overnight. So they have two options. They can either get the funds from another Fed member bank and borrow from them, or usually as a last resort borrow from the Fed. This tutorial is talking about this first situation, when they're borrowing from another Fed member bank.

So the Fed funds target rate is the rate that Fed member banks then are going to charge each other for these overnight loans, usually made to meet reserve requirements. So even though, yes, sometimes there are banks who will need to borrow money to meet their reserve requirement, there are also always going to be banks who have not loaned out the full amount permitted, either because they don't want to loan out exactly the full amount permitted, or because customers haven't demanded loans. They just haven't made as many loans as they're allowed to make.

When that's the case, we say that these banks have excess reserves, because they have reserves over and above what they are required to hold onto. When a bank with excess reserves lends some of these to another bank, usually overnight, that needs them, they charge the Fed funds rate. So we have a supply and demand situation. Supply are the banks with excess reserves. And demand are the banks needing to meet the reserve requirement.

Well, when we put supply and demand together, we usually get a market price, right? So this is creating a market. And the market price in this situation, the price to borrow money, is an interest rate. That's what setting here the Fed funds rate.

So if it's a market that's setting the rate, why are we talking about it as a Fed tool? Well, even though they don't directly set this rate, the FOMC does meet several times a year to set a target range for this rate.

So the idea is, the greater the supply of loanable funds, funds that banks can in fact loan out, that gives them the greater ability to make loans and then increase our money supply, get money out there circulating in our economy instead of being tied up in the bank. So if the Fed wants to increase the amount of loanable funds in the money supply, they could simply lower this Fed funds target rate. If they want to decrease the amount of loanable funds and keep money in the bank, contracting the money supply, then they could raise the Fed funds target rate.

So let's look at the first situation, an expansionary monetary policy, or sometimes known as easy money policy. This is when they want to get money out there in the circulation. So lowering the target Fed funds rate means that banks can borrow from one another at lower rates. That is going to make it easier for them to loan us money in turn. When it's easier for us to get loans, that has an expansionary effect on the economy.

The opposite of that is contractionary monetary policy, sometimes called tight money policy, making it more difficult to get our hands on money. So raising this target Fed funds rate means that banks have to pay higher rates to borrow from one another. In turn, that's going to make it slightly more difficult for them to loan us money. When it's harder or more expensive for us to get loans, that has a contractionary effect on the economy.

So in this tutorial, we talked about the several tools that the Fed has to manage our nation's money supply. But we've really focused on the Fed funds target rate as the one tool in this tutorial here. And it involves the rate that banks pay to borrow from one another. Banks might borrow from one another to meet their reserve requirement overnight.

So the big idea that we really looked at, though, is to expand the economy, the Fed can lower this target rate. That's expansionary policy. To contract the economy, the Fed can raise this target rate. And that's contractionary policy, or tight money policy.

Thanks so much for listening. Have a great day.

Terms to Know
Fed Funds Target Rate

The rate that Fed member banks charge other member banks for overnight loans— typically made to meet reserve requirements.