Federal Funds Rate – CPA Exam Definitions

Federal Funds Rate CPA Exam

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Federal Funds Rate

The federal funds rate is the interest rate at which banks and other depository institutions lend their excess reserve balances to each other overnight in the United States. It is a key benchmark rate used to influence monetary policy and is determined by the Federal Reserve, the central banking system of the United States.

Banks are required to maintain a certain level of reserves at the end of each business day, either as cash in their vaults or as deposits held at the Federal Reserve. Banks with excess reserves can lend to other banks that need additional funds to meet their reserve requirements. The interest rate charged for these short-term, typically overnight, loans is called the federal funds rate.

The Federal Open Market Committee (FOMC), a committee within the Federal Reserve, meets periodically to set the target range for the federal funds rate, based on its assessment of prevailing economic conditions and outlook. The Federal Reserve influences the federal funds rate through open market operations—buying or selling government securities in the open market—or by adjusting the discount rate, the interest rate charged on loans to banks made by the Federal Reserve itself.

The federal funds rate is an important tool for implementing monetary policy, as it directly affects short-term interest rates, liquidity in the banking system, and the overall cost of borrowing for businesses and consumers. When the Federal Reserve wants to stimulate the economy, it can lower the target range for the federal funds rate, making borrowing cheaper and encouraging banks to lend more. Conversely, when the Federal Reserve wants to cool down the economy and control inflation, it can raise the target range for the federal funds rate, making borrowing more expensive and discouraging excessive lending and spending.

Changes in the federal funds rate can have broad implications for the economy, including influencing economic growth, employment, inflation, and the exchange rate of the U.S. dollar.

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