In the U.S. banking system, the federal funds rate is the interest rate used as a guideline for banks loaning "federal funds" to one another.
What Are Federal Funds?
Federal funds are the excess reserves that private banks and other private financial institutions deposit in their accounts at their regional Federal Reserve bank. These funds can then be lent out to institutions needing additional capital to meet reserve requirements, cover operating costs for the next business day, or which have some other need for new capital, quickly and cheaply. Federal funds are lent out with very short periods of time, typically overnight, and are provided subject to agreement between the bank where the excess reserve originated and the bank that needs the funds. Usually, recipient banks do not need to (and cannot) pledge adequate collateral for the loans hence the relationship between the two parties engaged in the transaction bears considerable weight in the process.
How Is The Interest Rate Calculated?
The Fed funds "target" or "nominal" rate is a benchmark rate set by the Federal Open Market Committee, a part of the Federal Reserve System. This benchmark rate fluctuates through the Federal Reserve's use of Open Market Operations, so the real rate of interest paid between banks falls between a range around the target rate. It's good to note here that the said, "real interest rate paid" between banks is called the "effective" rate and the Federal Reserve attempts to keep its target rate as in tandem as possible with the effective rate.
How Is This Interest Rate Used?
The Federal Reserve can adjust its interest rate targets to either encourage or discourage lending between banks as the demand for money and credit changes. Lowering rates by increasing the money supply, encourages increased lending from banks, as the reduced range of interest rates make the loans less expensive. Conversely, raising rates by contracting the money supply has the opposite effect, making lending more expensive and thus less attractive.