Federal Funds Rate Economists had predicted that the federal funds rate for mark
ID: 1178259 • Letter: F
Question
Federal Funds Rate
Economists had predicted that the federal funds rate for market clearing would never drop to or below the interest rate that the Federal department pays on reserves, reasoning that banks could then earn at least the same rate of interest by holding reserves with the Federal department instead of making federal funds loans. In fact, government-supported and foreign financial institutions, which do not hold reserves with the Federal department but can borrow or lend on the federal funds market, have made loans to U.S. banks at federal funds rates market clearing below the Fed's interest rate on reserves.
Tasks:
Discuss how banks can profit from borrowing at a federal funds rate lower than the interest rate that the Fed pays on reserves.
Explanation / Answer
If banks borrow from other banks at a rate lower than the Fed pays, the can borrow an unlimited amount, put it on deposit at the Fed and make lots of profit. That's why the Federal funds rate is said to set a ceiling on the reserve deposit rate.
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