Question

Distinguish between the federal funds rate and the prime interest rate. Why is one higher than the other? Why do changes in the two rates closely track one another?

Short answer

The federal funds rate is for interbank loans, while the prime rate is for loans to businesses. The prime rate is higher due to banks' profit margins. They track each other as the federal funds rate influences the prime rate.

Step-by-step solution

Understanding the Federal Funds Rate

The federal funds rate is the interest rate at which banks lend to each other overnight. This rate is determined by the Federal Reserve through its open market operations and is a crucial tool for influencing the overall supply of money and credit in the economy.

Understanding the Prime Interest Rate

The prime interest rate is the interest rate that commercial banks charge their most credit-worthy corporate customers. This rate is generally higher than the federal funds rate because it includes a markup for the bank's profit and risk management.

Comparing the Two Rates

The primary difference between the two rates is that the federal funds rate applies to lending between banks while the prime rate applies to lending from banks to businesses. The federal funds rate acts as a benchmark for many other interest rates, including the prime rate.

Explaining Why the Prime Rate is Higher

The prime rate is set higher than the federal funds rate because it serves as a profit margin for the banks. Banks include additional interest to cover their operational costs and the perceived risk when lending to even the most credit-worthy customers.

Analyzing the Relationship Between the Rates

Changes in the federal funds rate influence the cost of borrowing for banks, which is then reflected in the prime rate, leading to their close tracking. When the federal funds rate changes, banks adjust the prime rate to maintain their profit margins as lending conditions change.

Key concepts

Federal Funds Rate

The federal funds rate is a crucial term often mentioned in economic discussions. It refers to the interest rate at which banks lend reserves to each other overnight. This rate is not set by a single authority but is determined in the open market. However, the Federal Reserve, which is the central bank of the United States, plays a significant role in influencing this rate.
The rate is a pivotal part of the Federal Reserve's monetary policy tools. By buying or selling government securities, the Federal Reserve can impact the supply of money in the market which in turn influences the federal funds rate. A lower rate means cheaper borrowing costs, which encourages spending and investment in the economy.

• Used as a guideline for other interest rates.
• A tool for managing inflation and economic growth.

The availability and cost of credit are largely tied to this rate, making it an influential tool for the Fed to stabilize the economy.

Prime Interest Rate

The prime interest rate is best understood as the benchmark interest rate that banks use when pricing for loans to their most credit-worthy customers. This rate applies typically to corporate clients and is generally higher than the federal funds rate.
Why does the prime interest rate have a larger number attached to it? The answer is simple. Banks factor in their operational costs, profit margin, and the risk assessment of lending. Even when lending to trustworthy clients, there is still a degree of risk and expense. Thus, banks add a markup to the federal funds rate to arrive at the prime rate.

• Benchmark for various consumer loan products like mortgages and credit cards.
• Reflects banks' view of risk and operational expense.

You'll often find that when the federal funds rate changes, the prime rate soon follows, adjusting to maintain the bank's necessary profit margins.

Monetary Policy

Monetary policy refers to the actions undertaken by a central bank, like the Federal Reserve, to regulate a nation's money supply and achieve macroeconomic goals such as controlling inflation, consumption, and economic growth.
There are a few tools in the monetary policy toolkit, with the federal funds rate being one of the primary instruments. This rate affects economic activity by making borrowing more or less expensive. For instance, a lower rate can spur economic growth by encouraging businesses and consumers to take out loans. On the other hand, a higher rate might discourage borrowing and spending, which can slow down economic inflation.

• Implementing changes in interest rates.
• Aim to manage economic cycles effectively.

Controlled by the Federal Reserve, monetary policy is about finding balance—stabilizing prices while fostering employment and sustainable economic growth.

Federal Reserve

The Federal Reserve, often simply called "the Fed," is the central banking system of the United States, established to provide the country with a stable and secure monetary and financial system.
The Federal Reserve has several core responsibilities, including controlling inflation, managing unemployment rates, providing financial services, and maintaining stability in the financial system. Among its many tools, controlling the federal funds rate is one of the most effective methods it employs to influence the economy.

• Composed of a Board of Governors and 12 regional Federal Reserve Banks.
• Regulates banking institutions to ensure the safety and soundness of the nation's financial and banking system.

The Fed also serves as a lender of last resort to support the banking systems during times of financial stress, aiming to promote the overall economic health of the country. Understanding the role of the Federal Reserve helps make sense of its decisions regarding interest rates and other economic policies.