Student Question

How does the Fed raise or lower the federal funds rate? 

Expert Answers

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Most usually, the Fed raises or lowers the federal funds rate through open market operations.  Open market operations consist of the Fed buying or selling government securities

The federal funds rate is the rate of interest that banks charge one another for very short term loans.  Banks sometimes find that they are short on cash and need money so as to have enough in reserve.  Meanwhile, other banks may have excess reserves.  The banks with excess reserves loan to banks that lack reserves.  The loan is typically only for overnight and must be paid back the next day.  The interest rate charged for this is the federal funds rate.

The Fed affects this rate by buying government securities from or selling them to the banks.  When the Fed buys securities, it is giving the banks more money.  The more money they have, the lower interest rate they will be willing to charge.  If they have less money, they charge higher rates.  The Fed sets a target for the federal funds rate.  It then engages in open market operations to try to hit that target. 

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