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Monetary Policy - The Federal Reserve

The federal funds rate is an interest rate that banks charge each other when they borrow funds overnight to keep the Federal Reserve requirement met. The Fed uses the federal funds rate for controlling interest rates that banks charge for loans and pay for deposits. Banks would lend every dollar they have but the Federal Reserve requires that they have a certain percentage of deposits on hand each night. If the federal funds rate is higher, it causes the banks to be less able to borrow money to keep their reserves at the required level. In turn, the banks will lend out less money and the money that is lent out will be at a higher interest rate. When the loans become more expensive and more difficult to obtain, businesses will not borrow as much and this will slow the economy. Now if the federal funds rate is lowered, the opposite happens. Overnight lending will be cheaper so the banks will more than likely borrow from each other to maintain their reserves. Since the rate is lower, the banks will lend more and at a lower rate. Businesses will borrow more with the cheaper bank lending and expand, which will boost the economy.
             The discount rate is the interest rate that the Federal Reserve banks charge other banking institutions on overnight loans to borrow at the Feds discount window. This rate is higher than the federal funds rate because the Federal Reserve wants to discourage excessive borrowing. Banking institutions would better benefit to borrow amongst each other instead of borrowing directly from the Federal Reserve. The federal funds rate and the discount rate have remained the same over the past year for good reason. There is no need to alter the rates at this time because the economy is maintaining itself.
             The final tool the Fed uses for monetary policy is the required reserve ratio. The required reserve ratio is a percentage of deposits that the Federal Reserve requires each bank to keep on hand.


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