The interest rate at which banks lend reserve balances to each other on an overnight basis. Depository institutions are required by law to maintain a certain percentage of their customer’s money in reserves, causing banks to lend money back and forth to maintain an acceptable level of cash on hand. Banks will try to stay as close to the minimum reserve limit as possible, as excess reserves earn a rate of return of zero and can lose value over time due to inflation.
Used to control the supply of capital in the economy, the federal funds rate has a net effect on inflation and other interest rates. In an inflationary environment, the Federal Reserve will raise rates to increase short-term interest rates and lower the supply of money. In a deflationary environment, the Federal Reserve will lower rates to decrease short-term interest rates, thus increasing available capital and spending.