Federal Funds Rate?

Question

1. If federal Funds Rate is the lending rate between institutions to institutions on overnight basis, how does that affect us or economy?

2. The interest rate we earne from depositing our money in the banks, what does this rate base on?

3. Can institutions deposit their money in Central Bank or Federal Reserves (I don't know if they are the same). Do they earn interests from that?

TO Ryan D.: The rate that the Federal Reserve charges institutions is call "discount rate" not Federal Funds Rate.

Answer 1

this might can help, it's not much...it comes from a book in my office, it's a Series 7 exam workbook:

"Federal funds rate - This rate is the interest rate charged on reserves among member banks for overnight use in amounts of $1 million or more. The federal funds rate changes daily in response to the borrowing banks' need and is considered the most volatile rate. The fed funds rate is a market rate of interest Unlike the discount rate, it is not set by the Federal Reserve. The effective fed funds rate is the daily average of selected money center banks throughout the country."

The discount rate is what the Federal Reserve charges to depositary institutions (banks, credit unions), and they would earn interest off of those loans. The individual banks loaning money between themselves would earn interest using the fed funds rate.

I'm not positive, but the interest that we earn in depository accounts would be off the prime rate...but like I said, I'm not sure about that one.

Answer 2

The Fed funds rate is a target rate.

The Fed manipulates the discount rate on a continuous basis in order to influenceth Fed funds rate.

As the Fed funds rate is a market rate,tehre is no way of setting it,only targeting a specific rate by manipulating the underlying interest rate (discount rate)

The more it costs banks to borrow, the morethey charge customers, the more customers have to pay, the less they will borrow. Companies are also customers and they pay for buildings, factories, etc with loans, so higher rates lead to less capital investments by companies which slows down the economy. On the personal side, it makes mrtgages, credit cards, etc more expensive, so poeple spend less, decreasing demand.

The interest rate banks pay is based on the prime rate, which is based on the fed funds rate. The prime rate and interest rates paid by banks are a fixed markup above the Fed funds rate.

companies are required to keep deposits at the Federal reserve bank - these reserves are to cover the withdrawals people make.

Answer 3

Your answers from Ryan are generally good-

here is a little more info on 2 however regarding deposit rates.

Banks LEND money to make money. Where do they get that money?? They borrow it from you and me. If loan demand is high in a certain area, you'll see CD rates and deposit rates go up slightly too. That is how they BORROW to lend to people or business. A CD might be paying 5.25% for 5 years ... so the bank is borrowing there. They then lend it out on a 5 yr car loan for say 7%. And that is how they make money. Banks sometimes have very low loan balances...ie, nobody in their area wants to borrow. That bank could be called a deposit bank and carry a large portfolio. They borrow in the traditional way...but then turn around and buy bonds at higher rates.

Deposit rates are supply/demand related but are still sensitive to fed funds and outside lending/borrowing rates.

Answer 4

The rate other banks charge each other relates to what they are willing to pay you. There is a margin there and they try to leverage that by borrowing at lower rates.

All financial institutions have reserve accounts (which they treat as their "checking account") but I don't think Fed pays interest.

Answer 5

You have asked a very complex series of questions which necessitate very long answers. Here we go.

The Federal Funds rate is *not* the lending rate between institutions. It is the lending rate from the US Federal Reserve (which is the official name of the US central bank: other countries call their central banks different things) to US commercial banks. Just like you and I use credit cards for short-term loans to keep our finances liquid, so banks borrow from the Federal Reserve to keep themselves liquid.

This affects the economy in pretty fundamental and maddeningly complex ways. But the simplest way of explaining it is that government bonds are generally the safest form of investment out there. The only way not to get a guaranteed return on your investment with a T-bill is if the Federal government defaults on its loans, and if that happens, well, it's basically the end of the world as far as the global economy is concerned. If the government ever defaults, losing out on a few investments is the least of everyone's worries: we're all up sh*t creek without a paddle.

That being the case, people are always looking for a balance of potential return on investment on one side and limited risk on the other. The ideal investment is high-return and low-risk. The rate at which the government borrows money (always in the form of Treasury bonds, known as T-bills), is directly linked to the Federal funds rate. So if the government is offering you 4% for your money at zero risk, everyone else has to offer more than that because they do present some risk. A really safe investment might go at 5%, and riskier ones on up from there. But what if the government is offering 8% or 10%? All of a sudden everyone else needs to offer even more than that, which gets really expensive really fast, because people are much more likely to be content with the guaranteed government investment than expose themselves to risk.

This is what is known as "crowding out". If government interest rates are too high, so many people invest their money in T-bills that there isn't enough left over for businesses and individuals to borrow. This makes borrowing even more expensive. And expensive borrowing really shuts down things like buying houses, business expansions, basically anything that involves taking on debt. *This*, in turn, slows down the rate at which the economy grows, which is generally considered to be a bad thing.

The other thing that interest rates affect is the "strength" of the dollar in comparison to other currencies. If the US government is offering 5% on its bonds but the UK is only offering 3%, everyone is going to want to sell pounds and buy dollars, because you can make more money there. People selling pounds and buying dollars equals more demand for dollars, which mean the value of the dollar compared to the pound will go up. On the other hand, if the US is offering 5% but the UK is offering 8%, the opposite will happen, and the value of the dollar will fall. A strong currency equals cheap imports, because a dollar will go farther overseas than it will at home. A weak currency means cheap exports, because other people's currency will go farther here than it does where they live. Both China and Japan rigorously manage the value of their currency to keep them artifically weak so that they have an advantage in global trade, though they tend to do this though means other than interest rates, of which there are several.

The interest rate you earn from depositing money in a bank is related to the Federal funds rate, though there isn't a direct one-to-one relationship, and deposit rates take some time to adjust to changes in the Federal funds rate. Banks make a profit by borrowing money at low rates and lending it at high rates, so your interest checking account will never pay anything more than the Federal funds rate, and will usually pay significantly less.

Central banks, including the Federal Reserve, aren't banks in the normal sense, and no one can make deposits in them. The closest you can get to investing in the government is by buying T-bills, but then the money goes to the Treasury department, which is rigorously isolated from the Federal Reserve. When the Federal Reserve lends money, it does so with money that is not currently in circulation. This increases the money supply. When banks repay their loans from the Fed, the money they use to do that leaves circulation. This is one of the ways the Fed controls inflation, which is basically controlling the growth of the money supply. When the Fed makes a loan, money is created, because the bank lends that money out at a higher rate of interest than they paid on it, so when they pay it back, the bank has more money than when it started. If the Fed thinks that money is being created too quickly, i.e. there is a danger of inflation, it will raise interest rates to discourage banks from borrowing by making it more expensive to do so. But no, no one may make an investment in a central bank, at least not in the way you would make a deposit at your local branch bank.

Answer 6

5.454%