Concept
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Federal funds refer to overnight loans made between two banks, whereby the lending party uses the reserves that they, as a bank, are required to keep at their governing central bank. This often refers to the United States, whose central bank, as you may recall, is named the Federal Reserve. The amount of money that a bank is required to keep at the central bank changes over time and is dependent on the relevant financial regulations and their financial positions (and is thus indirectly affected by factors, such as the political climate, discussed in Module 2). If a bank has a higher reserve amount than the stipulated requirement, they could withdraw it from the central bank or keep it in reserve and lend it to another bank that needs to increase its reserves. In such cases, the money would stay with the central bank under the name of the borrowing bank. The interest rate that banks negotiate for these loans is known as the federal funds rate, which is viewed as an important indicator of the economy’s well being. The federal funds rate gives an indication of the general level of interest rates and also suggests how banks perceive the likelihood of other banks
defaulting on their loans.