Summary - Essay Example

Chapter 2: Federal Funds Summary The concept of federal funds pertains to be forming the basis of theUS credit market while developing expectations on the interest rates in the money market. The Federal Reserves Regulatory shapes up the market growth and acts as the instrument for the country’s monetary policy. Characteristics of Federal Funds The federal features have three distinguishing features. They distinguish federal funds from other money market instruments. First, from the readily available money, they are the short-term borrowings, capable of being transferred in the duration of a single sat amongst various depository institutions.

Second, federal funds are the borrowings by the depository institutions which are directed to retain reserves in the Federal Reserves Bank according to the Monetary Control Act of 1980. Third, federal funds borrowed have been exempt from both reserve requirements and interest rate ceilings. The demand and supply of federal funds is the source of efficient distribution of funds in a banking system. Its lending and borrowing occur in federal funds market at a competitive interest rate known as the federal funds rate.

The funds are supplied to the overnight market by nonbank depositors through repurchase agreements (RPs) with their banks. The RP is tied close to the federal funds rate due to the competition among banks for funds. Methods of Federal Funds Exchange Either the borrower or the lender can initiate the transaction of the federal funds. However, in case of an institution switching to sell the federal funds, it requires locating a borrower either through an indirect broker for federal funds or with the help of direct bank relationship.

Normally, two methods are involved in the transfer of federal funds. First, the district reserve back is authorized by the lending institutions to debit the reserve account and credit the account of borrowing institution. On the other hand, the second method re-categorizes the demands of respondent bank in the form of borrowed federal funds. Types of Federal Funds Instruments One of the commonest types of the federal funds instrument is an unsecured, overnight loan which is transacted between the two financial institutions.

Federal funds loans are generally arranged as term and continuing contract federal funds. In the term federal fund contract, a fixed interest rate and fixed term to maturity is specified. However, the continuing funds automatically renew as long as they are not terminated by the borrower or lender. Determination of the Federal Funds Rate The aggregate stock of reserves available to the banking system is determined by the Federal Reserve. Figure given above depicts the aggregate demand schedule for bank reserves, in which, R is aggregate bank reserves and f is the funds rate.

By providing fixed stock of reserves to the bank, the R on left would be provided through Federal Reserve purchases of government securities. Then f *, in Figure 1, would be the ultimate funds rate would. In other words, it would be the rate which would equate the aggregate demand and supply for the bank reserves. Thus, federal funds are just like the old loan market. They facilitate the federal reserves distribution amongst numerous banks and provides the basis of an overnight credit market.

Works Cited Timothy Q. Cook and Robert K. Laroche, (1993). “Federal Funds.” Instruments of the Money Market: 1993, 7-20. Print.