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An introduction to the federal funds market

Federal funds market

I find definitions of the federal funds rate stating that it can be both above and below the discount rate. September 2004 Great question! The correct answer depends on the time period. The fed funds rate is the interest rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans.

The discount rate is the interest rate that Federal Reserve Banks charge when they make collateralized loans—usually overnight—to depository institutions. The federal funds market The fed funds rate and the discount rate are two of the tools the Federal Reserve uses to set U. First, you should know that depository institutions are required by the Federal Reserve to keep a certain amount of their deposits as required reserves, in the form of vault cash or as electronic funds in reserve accounts with the Fed.

Banks with excess funds typically lend them overnight to other banks that are short on funds, rather than leaving those funds in their non-interest bearing reserve accounts at the Fed or as idle vault cash. This interbank market is known as the federal funds market and the effective interest rate on daily transactions in this market is known as an introduction to the federal funds market federal funds rate. As of September 2004, U. An Introduction describes how the fed funds market works: The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate.

For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.

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Monetary policy and the fed funds rate For monetary policy purposes, the Federal Reserve sets a target for the federal funds rate and maintains that target interest rate by buying and selling U. When the Fed buys securities, bank reserves rise, and the fed funds rate tends to fall.

When the Fed sells securities, bank reserves fall, and the fed funds rate tends to rise. The discount rate is the interest rate that banks pay on this type of collateralized loan.

The following quote an introduction to the federal funds market the U. An Introductiondescribes how the discount window works and the discount rate is set: The Boards of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board… Since January 2003, the discount rate has been set 100 basis points above the funds rate target, though the difference between the two rates could vary in principle. Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives.

At the same time, the relatively easy availability of reserves at this rate effectively places a ceiling on the funds rate. Which rate was higher? Historically the federal funds rate has been both above and below the discount rate, although until 2003 the funds rate typically was above the discount rate. Until January 2003, it was possible for the effective fed funds rate to fall below the discount rate on occasion; however, normally the funds rate exceeded the discount rate.

This relationship can be seen in the Chart 1, which plots both the interest rates and the difference between the two rates.

  1. Chart 1 Endnotes 1.
  2. Chart 1 Endnotes 1.
  3. The Boards of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board… Since January 2003, the discount rate has been set 100 basis points above the funds rate target, though the difference between the two rates could vary in principle. First, you should know that depository institutions are required by the Federal Reserve to keep a certain amount of their deposits as required reserves, in the form of vault cash or as electronic funds in reserve accounts with the Fed.

The effective fed funds rate in black and the discount rate in yellow before 2003 and red after 2002 compare the level of interest rates—note that since the January 2003 change in discount window policy the discount rate has exceeded the fed funds rate.

Before 2003, the line showing the difference between the two interest rates shown in orange indicates that the funds rate typically was above the discount rate by a small margin. Chart 1 Endnotes 1. For current reserve requirements, please see Reserve Requirements of Depository Institutions at: References Instruments of the Money Market. Board of Governors of the Federal Reserve System.