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Federal Funds Rate

The federal funds rate is extremely important to the U.S. economy because it is the interest rate that commercial banks, also called depository institutions, charge to other lending institutions who are taking out short-term loans, usually overnight.

Why Do Banks Loan to Each Other?

Every night, banks need to have a set amount of money to operate the next day. They are required by law to have this. So, if banks are short this amount at the end of the day, they take out an overnight loan from other banks to meet the requirements. The banks who can give out the loans are banks that have excess money for the day. So, these banks can loan some of that excess money at the federal funds rate. This is important because it helps keep banks afloat and able for consumers to use, which helps keep the economy as a whole running.

How is the federal fund rate determined?

The Federal Open Market Committee (FOMC), a committee of 12 people that determines financial policy in the U.S., will set a target goal for the federal funds rate. However, because this rate is based on supply and demand and whether banks have an excess in funds to lend out, the actual rate may be different from the target rate set by the FOMC.

How is the federal funds rate used?

The federal funds rate is used by banks every day to make money by lending to other banks who are short on cash for the day. It's also a way for banks to raise capital quickly if they need money to complete an important project or make a certain loan. If the federal funds rate gets too high, it will be hard for banks to borrow money. If banks get too short on cash, that affects consumers negatively. The federal funds rate is imperative for banks to be able to loan out money, as well as borrow money from each other, to ensure they close their books each night with an adequate amount of cash to help consumers the following day.

What does the federal fund rate mean to you?

The federal funds rate affects individuals, especially if it fluctuates too much. If the federal funds rate gets too high, then banks have a hard time borrowing. If your bank has a hard time borrowing money to meet their needs, then they will have a hard time turning around and loaning you money for your needs, like buying a home or taking out a personal loan. So, it's important to keep tabs on the federal fund rate because it does have a significant impact on the way the economy, as a whole, runs.