Why do economists analyze the Fed's interest rate on the Federal Funds Rate, which is not set by the Fed?
The Fed Funds Rate is negotiated between banks, not set by the Fed. Why then do economists measure this rate to see what the Fed will do with inflation? Is their "rate" only a goal for Fed Funds Rate? If it is only a goal, do banks actually follow it? 10 for an economic answer!
Answer:
You are right that the Fed does not directly determine the federal funds rate, the rate of interest that banks charge one another for borrowing reserves. As you suggest, the Fed only sets a target for this rate. However, the Fed's behavior in the market for U.S Treasury securities (i.e., it's open market policy) affects the federal funds rate that actually prevails. Specifically, when the Fed sells securities, many of the bonds that it sells are purchased by banks, which reduces the supply of reserves that banks have to lend out, which in turn puts upward pressure on the federalfunds rate. Conversely, when the Fed buys securities, many of the bonds that it buys are bought from banks, which increases the supply of reserves that banks have to lend out, which in turn puts downward pressure on the federal funds rate.
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Answer:
You are right that the Fed does not directly determine the federal funds rate, the rate of interest that banks charge one another for borrowing reserves. As you suggest, the Fed only sets a target for this rate. However, the Fed's behavior in the market for U.S Treasury securities (i.e., it's open market policy) affects the federal funds rate that actually prevails. Specifically, when the Fed sells securities, many of the bonds that it sells are purchased by banks, which reduces the supply of reserves that banks have to lend out, which in turn puts upward pressure on the federalfunds rate. Conversely, when the Fed buys securities, many of the bonds that it buys are bought from banks, which increases the supply of reserves that banks have to lend out, which in turn puts downward pressure on the federal funds rate.
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