Question

What is the federal funds rate? Would you classify the federal funds rate as a policy instrument, and operating target, an intermediate target, or a policy goal? Explain.

Answer 1

The federal funds rate relates to the rate of interest that banks charge other banks overnight to lend them money from their reserve deposits. Through regulation, banks have to hold a balance equal to a certain amount of their Federal Reserve bank deposits in an account. Any cash that reaches the required level in their fund is available for lending to other banks that may have a shortfall. The bank's end-of-day balance, calculated over two-week reserve maintenance periods, is used to determine if it meets its reserve requirements. If a bank expects end-of-day balances to be lower than what is required, it can lend the excess amount to an entity that anticipates a balance default. The interest rate that can be paid by the borrowing bank is referred to as the federal funds rate or the fed funds rate.

While the FOMC can not mandate a specific rate of federal funds, the Federal Reserve System can adjust the supply of money to move interest rates toward the target. It can cause interest rates to fall by increasing the amount of money in the system; it can cause interest rates to rise by lowering the money supply.

Intermediate targets refer to any economic parameter that is important to the economy and not under the Federal Reserve's direct control. Types include things like money supply and interest rates. While these priorities are part of the monetary policy goals of the central bank, they are affected only indirectly by the monetary policy decisions of the Fed. Intermediate targets help guide policy as a step between the specific resources of the Fed and its priorities.Generally speaking, intermediate goals change quickly to suit new policy decisions but act predictably compared to the specified economic goals of the Federal Reserve. Such targets often have to do with either economic growth or interest rates.