Question

explain why the federal funds rate is essential in the conduct of monetary policy. Limit your answer to 400 words.

Recall that we examined when, why, and how the federal reserve was created. We also examined how independent the Fed is. It is important to remember that reserves are deposits a bank has with the Fed. Accordingly, reserves are assets for the banks and liabilities for the Fed. By increasing/decreasing reserves, the Fed’s goal is to increase/decrease liquidity in the banking system. Keep this in mind when you answer the question above.

Answer 1

Federal funds rate is essentially the rate at which commercial banks can borrow money from the Fed. Banks usually borrow to meet their minimum requirements. It is a very essential tool for the conduct of monetary policy because this ultimately determines how much money is there for the consumers to borrow.

These rates affect the monetary conditions which will finally have an impact on the employment, inflation and growth in the country. Since the Fed cannot directly control these variables, they use the federal funds rate as a tool to keep the inflation in check. So, the Fed's ultimate goal is to control the liquidity in the market and by setting an appropriate rate they can achieve their goal. For instance, if there is inflation prevailing in the economy, the Fed can raise the federal funds rate to lower the inflation in the economy. When the Fed raises the rate, it becomes more costly for the banks to borrow funds which is then passed on the consumers to borrow which therefore reduces the money supply in the economy, finally leading to a reduction in the inflation.