From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a depositor writes a check against his account, that bank must surrender that amount in reserves to the payee’s bank for the check to clear. Reserves are constantly moving from one bank to another as checks are written and cleared. At the end of the day, some banks will be short of reserves and others long. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need.

Banks redistribute reserves among themselves by trading in the Fed funds market. Those long on reserves will normally lend to those short. These loans take place in a private financial market called the federal funds market. The interest rate on the overnight borrowing of reserves or interbank loans is called the federal funds rate. It adjusts to balance the supply of and demand for reserves and will consequently vary with supply and demand. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.

The fed funds rate is the base rate to which other money market interest rates are anchored. Financial managers compare the federal funds rate with yields on other investments before choosing the combinations of maturities of financial assets in which they will invest or the term over which they will borrow. Interest rates paid on other short-term financial securities often move up or down roughly in parallel with the funds rate. Long-term rates are determined in part by expectations for the federal funds rate in the future. Financial institutions will determine money market rates according to their views of the current and future federal funds rates.

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