What is the federal funds rate? What are the main determinants of the federal funds rate?

Question

What will be an ideal response?

Answer 1

The federal funds rate is the interest rate banks charge for overnight loans. Banks may lend excess reserves in order to earn interest. Banks may borrow reserves in order to meet their reserve requirement or meet their customer’s need for money. Demand for reserves is based on several variables. As federal funds increases, for example, the opportunity cost of holding excess reserves increases and banks will want to lend out more reserves (as opposed to holding these reserves). The demand for reserves is based on the reserve requirement, the price level, and income. If the price level rises, people and businesses need to hold more money to carry out the same purchases of goods and services. If income rises, people spend more and need money to carry out these transactions. Either of these would lead to an increase in the federal funds rate as reserves become more scarce.Reserves supply is affected by the Fed’s monetary policy, especially its use of open-market operations. For example, an open-market purchase increases the supply of reserves banks have available, causing a decrease in the federal funds rate.