A high federal funds rate discourages banks from borrowing from one another, which tightens the money supply. Raising the federal funds rate is one of the most common measures taken by the government to combat high inflation.

The federal funds rate is the interest rate at which banking institutions loan money to each other overnight so that reserve requirements are met. The Federal Reserve requires all banks and thrift institutions to begin and end each day with a minimum level of reserves. These reserves can be held as cash in vaults or at the Fed. The minimum reserve requirement is usually 10% of a bank's total deposits and exists to prevent bank runs, which nearly brought down the entire U.S. economy following the 1929 stock market crash. Because banks must keep a percentage of total deposits readily available, they cannot lend every dollar they have, reducing the possibility of running out of cash for customers seeking withdrawals.

When a bank lends prolifically and finds its required reserves short at the end of the day, it has two options. The bank can borrow the money from the Federal Reserve itself at the discount window, or it can borrow the money from another bank. If it borrows from the Federal Reserve, the interest rate charged is the discount rate. The Fed has full autonomy over setting this rate, which is usually higher than the federal funds rate. If it borrows from another bank, the interest rate charged is set by the other bank. The federal funds rate is the prevailing market rate banks charge each other in this scenario.

A high federal funds rate creates an incentive for banks to avoid lending so much that their reserves dip below the required minimum, forcing them to borrow from other banks to make up the shortfall. Even though these are overnight loans and the money is usually paid back within a day, their dollar amounts often reach into the millions, and high interest on top of that amount cuts into a bank's profits. Lower levels of lending by banks translate to less money circulating through the economy. Businesses find it more difficult to procure capital, and individuals have a harder time obtaining credit.

Constricting the money supply via a higher federal funds rate is an effective monetary policy for tamping down high inflation. Former Federal Reserve Chairman Paul Volcker famously pushed interest rates as high as 20% during the early 1980s to bring down an inflation rate that had reached nearly the same level. A basic macroeconomics tenet states that when the money supply shrinks, money itself becomes more valuable. The U.S. dollar's strength during the 1980s was due in part to Volcker's actions.

  1. What's the difference between the prime rate and the discount rate?

    Learn more about the prime rate and the discount rate and how the Federal Reserve uses these rates in the U.S. economy. Explore ... Read Answer >>
  2. What is the relationship between inflation and interest rates?

    As interest rates are lowered, more people are able to borrow more money, causing the economy to grow and inflation to increase. Read Answer >>
  3. How does the Federal Reserve determine the discount rate?

    Learn about the several different kind of discount rates offered to banks and other depository institutions through the Federal ... Read Answer >>
  4. Who determines interest rates?

    In countries using a centralized banking model, interest rates are determined by the central bank. In the first step of interest ... Read Answer >>
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