Introduction to Finance

federal funds rate
,
 
which is 
the rate on overnight loans from banks with excess reserves to banks that have defi cit reserves. 
Open-market purchases of securities add to bank reserves and increase the money supply. 
Sales of securities lower reserves and the money supply. However, when the target is the 
money supply, interest rates may fl uctuate widely, because the demand for money may change 
relative to a specifi c money supply target. Furthermore, a focus on the money supply might 
not produce the desired impact on gross domestic product because of changes in the velocity 
of money, as we saw in Chapter 2.
In recent years, the Fed, through its FOMC, has chosen to focus on setting target interest 
rate levels for the federal funds rate as the primary means of carrying out monetary policy. 
Banks with excess reserves lend to banks that need to borrow funds to meet reserve require-
ments. Interest rates, such as the federal funds rate, refl ect the intersection of the demand for 
reserves and the supply of reserves. Open-market purchases of securities cause the federal 
funds rate to fall, whereas sales of securities cause the rate to rise. Of course, while the FOMC 
can set targets for federal funds rates, actual federal funds rates are determined in the market 
by banks with excess reserves and banks that need to borrow reserves to meet their minimum 
reserve requirement. 
The Fed uses its open-market operations to provide liquidity to the banking system in 
times of emergency and distress. For example, the stock market crash on October 19, 1987, 
caused concern about a possible economic collapse. The Fed, through FOMC open-market 
purchases, moved quickly to increase the money supply. The terrorist attacks on September 
11, 2001, caused widespread concern about the near-term ability of stock and other fi nan-
cial markets to function properly with a related possibility of economic collapse. The FOMC 
moved quickly to provide liquidity to the banking system, and to encourage renewed confi d-
ence in the fi nancial system by reducing the target rate for federal funds on September 17, 
2001, from 3.5 percent to 3.0 percent. 
In 2001, the FOMC further lowered its target for the federal funds rate to 2.5 percent 
on October 2, to 2.0 percent on November 2, and fi nally to 1.75 percent on December 11. A 
target rate reduction to 1.25 percent occurred on November 6, 2002, and this was followed 
by a further reduction in the target rate to 1.0 percent on June 25, 2003. As the U.S. economy 
began growing, concern shifted to the possibility of renewed infl ation, causing the Fed to 
begin increasing the target for the federal funds rate in 2004. 
Although the target for the federal funds rate was 5.25 percent at the end of 2006, target 
rates were reduced quickly as the 2007–08 fi nancial crisis developed and the 2008–09 Great 
Recession began. In December 2008, the FOMC established a near-zero target federal funds 
rate range, between 0.00 and 0.25 percent. This 0.00–0.25 percent target was subsequently 
maintained until December 2015 when the target federal funds rate range was increased to 
0.25–0.50 as the initial step toward monetary policy normalization. Actual federal funds 
rate data collected by the St. Louis Fed Reserve Bank shows a close correlation between