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DERIVED DEMAND: The notion that the demand for a factor or production, an input used in the production of a good, depends on the demand for the output being produced. This concept highlights the two key aspects of factor demand. One is that factor demand depends on the value of the good being produced. Inputs that produce more valuable outputs are themselves more highly valued. Two is that factor demand depends on the productivity of the input. Inputs that produce more output are themselves more highly valued.

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FEDERAL FUNDS RATE:

The interest rate charged by one commercial bank or depository institution for lending Federal Reserve deposits to another commercial bank or depository institution. This is the interest rate determined in the Federal funds market. The Federal funds rate is a key interest rate for both the banking system and the macroeconomy. It is often targeted by monetary policy and is a benchmark used to determine other interest rates in the economy.
The Federal funds rate is the interest rate charged for Federal funds lending. This interest rate is one of the more important in the macroeconomy. It is watched by policy makers, business leaders, financial investors, astute consumers, and others with an interest in financial markets, banking, and the macroeconomy.

Contrary to popular misperception, the Federal funds rate is NOT set by the Federal Reserve System (the Fed), but rather determined by the interaction among borrowers and lenders in the Federal funds market. The Fed can influence the Federal funds rate through monetary policy, but it does not actually set the rate.

The Federal funds rate is a key benchmark rate for the banking system. In one sense, it represents the basic cost of obtaining funds, funds that can then be used for consumer and business loans. As such, other bank interest rates are invariably linked to the Federal funds rate. Should the Federal funds rate increase, then interest rates on car loans, construction loans, mortgage loans, and others will also increase.

Federal Funds

Federal funds are the deposits that commercial banks hold with the Federal Reserve System, that is, Federal Reserve deposits. These deposits are an important component of the reserves that banks keep to back up deposits (the other component is vault cash). The term Federal funds is commonly used when these deposits are loaned from one bank to another. The lending of Federal funds is a common practice among modern commercial banks.

Motivation for Federal funds lending arises from reserve requirements imposed on commercial banks by the Federal Reserve System (the Fed). Reserve requirements are rules imposed by the Fed to ensure that all bank depository institutions (traditional banks, savings and loan associations, credit unions, mutual savings banks, and even U.S. branches of foreign banks) keep enough reserves to back up customer deposits. The bank depository institutions have a two-week period to satisfy the requirements.

Due to the normal fluctuation of banking activity, some banks have more reserves than needed to satisfy requirements and some have fewer. On a given day, one bank might have a large number of withdrawals that temporarily reduce reserves while another bank has a large number of deposits that temporarily expand reserves. The temporary lending of reserves is a logical response to such imbalances among banks. Banks that borrow reserves are able to satisfy reserve requirements and banks that lend reserves generate extra revenue for their trouble. This is a win-win exchange for both sides.

The Federal Funds Market

The Federal funds market is the organized mechanism used to facilitate the lending of Federal funds among banks. While traditional banks are the most noted participants in the Federal funds market, other entities with Federal Reserve deposits are also involved. The list includes traditional banks, savings and loan associations, credit unions, mutual savings banks, branches of foreign banks operating in the United States, federal agencies, and dealers who trade in government securities.

The first Federal funds loan between banks took place in 1921, less than a decade after the Federal Reserve System was created. The Federal funds market became quite active in the 1920s, but its use ebbed and flowed over the ensuing decades. It became increasingly active in the 1960s as it proceeded to assume its current position as a key component of the modern commercial banking system.

While the Federal funds market is extremely active, day in and day out, the market is somewhat informal. Written contracts are occasionally used, but most loans are only based on verbal agreements.

  • Bank to Bank: Most Federal funds lending is between banks with established working relationships. A short telephone call between banks is often enough to reach agreement on the terms of the loan. The lending bank then contacts the Federal Reserve System with instructions to transfer Federal Reserve deposits to the account of the borrowing bank. The process is quick, easy, and efficient.

  • Federal Funds Brokers: Some loans, however, are arranged by third party Federal funds brokers, who specialize in matching up banks in need of reserves with banks who have extra reserves to lend. The brokers, of course, charge a commission for their effort, but they expand the market, providing greater access of lenders to potential borrowers and borrowers to potential lenders. The borrowing bank need not have an established relationship with the lending bank.

A Key Rate

The Federal funds rate is one of the more important interest rates in the economy.
  • First and foremost, it is a benchmark interest rates commonly used to determine other interest rates. Other interest rates that are usually pegged to the Federal funds rate include interest rates that banks pay on deposits (savings deposits, certificates of deposits, individual retirement accounts, Eurodollars, repurchase agreements, etc.) and interest rates that banks charge for loans (car loans, construction loans, mortgage loans, development loans, real estate loans, small business loans, etc.).

  • Second and also important, the Federal funds rate is a key indicator of economic activity. As a benchmark for other interest rates, policy makers, business leaders, financial investors, astute consumers, and others with an interest in financial markets, banking, and the macroeconomy keep a close on the Federal funds rate. The Federal Reserve System regularly targets the Federal funds rate when pursuing monetary policy--a lower rate to reduce unemployment and a higher rate to control inflation.

  • Third and well worth emphasizing, the Federal funds rate is an important component of the costs of acquiring funds. Banks obtain the funds they use for loans from a variety of sources. The most important source, of course, is customer deposits. Another seldom used source is discount borrowing from the Federal Reserve System. A key source, however, is the Federal funds market, making the Federal funds rate something of a baseline cost that banks can expect to pay for acquiring funds.

And Monetary Policy

The Federal funds rate is critical to the conduct of modern monetary policy. The Federal Reserve System commonly targets the Federal funds rate when it sets a course of monetary policy. If the Fed seeks expansionary monetary policy, then it targets a lower Federal funds rate. If it pursues contractionary monetary policy, then it targets a higher Federal funds rate.

The connection between monetary policy and the Federal funds rate is so close than many people erroneously assume that the Fed is in direct control of the Federal funds rate. This is not true. The Fed does not directly control the Federal funds rate, but it does manipulate the rate by influencing the Federal funds market, which it accomplishes through open market operations.

If the Fed deems that a lower Federal funds rate is needed to stimulate the economy out of a recession, then it increases the total amount of Federal funds (Federal Reserve deposits) held by the banking system with the purchase of U.S. Treasury securities through open market operations. These additional reserves, similar to the supply increase in any market, motivates banks to loan Federal funds at a lower Federal funds rate.

Alternatively, if the Fed thinks a higher Federal funds rate is in order to restrain the economy and reduce inflationary pressures, then it decreases the total amount of Federal funds held by the banking system with the sale of U.S. Treasury securities through open market operations. This reduction of reserves, similar to the supply decrease in any market, motivates banks to loan Federal funds at a higher Federal funds rate.

<= FEDERAL FUNDS MARKETFEDERAL OPEN MARKET COMMITTEE =>


Recommended Citation:

FEDERAL FUNDS RATE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: January 23, 2018].


Check Out These Related Terms...

     | Federal funds | Federal funds market | Federal Reserve System | reserve requirements | monetary policy | Federal Open Market Committee | Federal Reserve Banks | monetary economics | open market operations | discount rate | tight money | easy money | expansionary monetary policy | contractionary monetary policy | bank balance sheet |


Or For A Little Background...

     | Federal Reserve deposits | bank reserves | vault cash | fractional-reserve banking | banks | money | bank panic | check clearing | money creation | macroeconomics | monetary base | monetary aggregates | macroeconomic goals | market | financial markets |


And For Further Study...

     | central bank | Federal Reserve pyramid | Board of Governors, Federal Reserve System | Chairman of the Board of Governors, Federal Reserve System | Federal Deposit Insurance Corporation | Comptroller of the Currency | business cycles | unemployment | inflation | barter | aggregate market | gross domestic product | circular flow | goldsmith money creation |


Related Websites (Will Open in New Window)...

     | Federal Reserve System |


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