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Finance Glossary

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Federal Funds Rate


To understand federal funds rates, you need to understand how banks work. (Fun!)

Your bank takes money from people depositing cash at the bank and lends money to borrowers (like the guy applying for a loan to buy a Maserati). So there's money coming in and money going out. The bank needs to keep a reserve, or a certain amount of money on hand, so that when a bunch of people come in for their cash, the bank can't say "sorry, we gave it all to the nice man wanting to buy a sports car." That kind of thing leads to panic and disaster.

What happens when a bank has less money than it legally needs to have as a reserve? It borrows money in a short-term, overnight loan from either the Federal Reserve Bank or from other banks that keep their own reserves at the Federal Reserve. Now, we all know that borrowing money is not free. If a bank borrows overnight from other banks, it is charged an interest rate at the current federal funds rate. The Federal Reserve influences the federal funds rate.

Why should you care how much interest banks charge each other? The federal funds rate has a big impact on the interest you are charged if you need to borrow money. When the Federal Reserve nudges the federal funds rate lower to stimulate the economy, you'll pay less for loans. When the federal funds rate goes up, borrowing gets more expensive for you.