Federal Funds Rate is the interest rate that banks charge each other when loaning bank reserves through the Federal Funds Market. All banks are subject to reserve requirements, but frequently fall below requirements in the carrying out of day-to-day business. To meet requirements they have to borrow from each other’s reserves. This creates a market in reserve funds, with banks borrowing and lending as needed at the Federal Funds Rate. Therefore, the Federal Funds Rate is important because by increasing or decreasing it, the Federal Reserve(Fed) can impact (over time) practically every other interest rate charged by U.S. banks. This is also a key interest rate in the economy because helps to determine banks’ minimum cost of getting funds. If the Federal Funds Rate is higher, then banks are likely to raise the interest rates they charge, like the prime rate, home mortgage rate, or rate on car loans. The Federal Funds Rate may vary from bank to bank and from day to day (appendix). A decrease in the federal funds interest rate could reflect the decision by the Fed to stimulates economic growth, but an excessively high level of economic activity can cause inflation pressures to build to a point that ultimately undermines the sustainability of an economic expansion. An increase in the federal funds interest rate will curb economic growth and help contain inflation pressures, and thus can promote the sustainability of an economic expansion, but too large an increase could retard economic growth too much.
The money supply can be defined as notes and coins circulating outside the central bank. It is designed to control the amount of money flowing around the economy. The money supply is controlled by the Fed through its monetary policy stabilise the business cycle. As the nation’s central bank, the Fed determines the total amount of money circulating around the economy. In principle, the Fed can use three different ‘tools’--open market operations, the discount rate, and reserve requirements to manipulate the money supply. In practice, however, the primary tool employed is open market operations. To counter a recession, the Fed would undertake expansionary policy, also termed easy money. To reduce inflation, contractionary policy is the order of the day, and goes by the name tight money. However, there are some effects of using the monetary policy. For instance, if the interest rates are raised then borrowing by businesses is made more expensive and might lead to cancellation of investment projects. Higher interest rates will also hit the pockets of many consumers. They will find it more expensive to borrow money on credit and their mortgage repayments will also increase. This is likely to lead to fewer sales, especially for those firms manufacturing and selling consumer goods.
