Question

Explain the concept of federal funds rate and explain how this rate impacts consumers

Answer 1

Federal funds rate & its impact on consumers:

Federal funds rate is the interest rate banks & depository institutions charge each other for lending Federal Reserve funds (balances reserved at Federal Reserve banks) overnight. When a banks has surplus balance in its reserve account, it lends it to other banks which require larger balance to be maintained. The rate that borrowing banks pay to lending institutions is called effective federal funds rate which is determined by Federal Reserve through open market operations. The FOMC (Federal Open Market Committee) sets a target for the fed funds rate & uses open market operations like buying and selling of government bonds to achieve it. Federal Reserve raises federal funds rate by selling government bonds to decreases liquidity. Similarly it decreases it by buying government bonds to increase liquidity in the economy.

Impact:

It is one of the important tool in Federal Reserve’s policy actions to influence money supply & financial conditions in the economy. It helps in maintaining price stability & sustainable growth. If Fed lowers Federal funds rate it encourages borrowing and investing as banks have more balance in reserve accounts. Lower interest rates lead to lower cost of debt which helps consumers who have mortgages, loans or credit cards. It increases employment opportunities as business tend to increase capital investment & expansion. Consumers get benefitted by low interest rates on their long term liabilities.

Similarly when Fed increases Federal Funds rate it can discourage borrowing & investing due to increased interest rates. Higher interest rates lead to higher cost of debt which increases the cost of long term liabilities. Higher interest rates slow inflation & return growth to more sustainable levels.