Question

1) What is the federal funds rate?

2) How does the current 2.00-2.25% federal funds rate affect consumers today?

3) How does an increasing federal funds rate up to 2.5% by next year mean for the economy?

Answer 1

1) Federal funds rate is the interest rate at which banks borrow overnight from other banks.

2) A low federal funds rate ensures high liquidity in the economy as banks keep less excess reserves because the borrowing cost of excess reserves is less than holding cost of excess reserves as they can be lent out.

3) If federal funds rate is increased, the banks will keep excess reserve with them as borrowing cost has increased, this will lead to decrease in money supply in the economy which at given money demand will push the interest rate upwards. This increase in interest rate will increase cost of borrowing for public leading to fall in consumption and investment. This leads to fall in aggregate demand for goods and services which at given aggregate supply pushes the price level and output down and unemployment rate up.

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