Federal Funds???

Question

In what ways is the federal funds rate a measure of the tightness or looseness of the monetary policy?

What was the logic of those actions?

Answer 1

The fed funds rate is the interest rate paid by one bank to another bank to borrow federal funds. Banks are required to place a fixed percentage of their deposits with the Federal Reserve every couple of weeks. If their deposits go up, they need to increase the funds. If they go down, they have a choice -- they can either withdraw their funds or lend them to someone else who needs them.

Banks have two main ways to get the cash to increase their deposits. They can either borrow those funds from another bank, or lend out securities in the Repo Market & use the cash for the Fed Deposit.

The Federal Reserve would like to control the Fed Funds rate. If they can push it down, it makes money easier to borrow & loosens credit. If they push it up, it makes money harder to borrow and tightens up money. While the Fed would like to set this rate -- they can't just set it to something by command. The market decides what it should be -- based on sullpy and demand. By law, the Federal Reserve is not a player in this market -- they are not allowed to buy or sell federal funds.

But the Federal Reserve is a player in the Repo Market. By buying or selling in that market, they can push Repo rates up or down. Since banks have a choice of funding in the two markets, the markets will move together.

By lending out securities, the Fed is increasing the supply of securities -- pushing down their prices (and pushing up rates). This, in turn, makes it harder for people to borrow money.

By borrowing securities, the Fed decreases supply -- increasing the prices of securities and pushing down rates.

Answer 2

Taranto has given a great explanation. The fed can affect the economy with 2 tools they have at their disposal. The minor tool are interest rates (the Fed Funds Rate and Discount Rate). The discount rate is the rate the Fed charges member banks for loans. The Fed funds rate is the rate member banks charge each other for overnight loans to meet reserve requirements. So the fed funds rate is the "cost of money". If inflation is growing, they'll raise rates, so it makes it more expensive to borrow, thus people/business spend less driving down inflation or holding it steady. If the economy slows too much, the fed will lower interest rates, thus making it cheaper to borrow and "enticing" people/business to borrow and spend, thus pumping up the economy.

The second tool which is the major tool is the Federal Open Market Operations. Through the OMO, the fed can add or remove liquidity from the banking systems excess reserves. This is the "availability of money". When the fed buys government bonds, they add liquidty to the excess banking reserves and increase the money supply. To decrease the money supply, they sell gov't bonds.

Increasing liquidity is inflationary because the more money that is created, the more you drive inflation (do a google search on the Hyperinflation in Post WW1 Weimar Republic Germany as how creating money drives inflation).

So, the Open Market Operations (OMO) is "availability of money" and the fed funds rate is "cost of money". Both affect monetary policy, but most people only pay attention to the fed funds rate. The should be paying attention to the OMO also as that has the greatest impact on inflationary pressure.

Answer 3

WOW... this is a great question (esp.part #2).The Federal Reserves main charter is to be the governments main arm against inflation.

Increasing the rate slows growth (large growth can be very inflationary), Decreasing the rate allows for more growth (it's cheaper to borrow money, so business can invest more & grow).

The balance between what's best at any given time is very hard to determine.

In short: This question requirers some serious reading on your part. A quick answer on Yahoo is not the way to explain it all.

Good luck!