Lesson 4 Federal Funds Rate/ Bonds

What is the Federal Funds Rate?

the interest at which banks lend reserve balances to other depository institutions with low funds

What is the purpose of the federal fund rate?

used to influence monetary policy and economic conditions

affects borrowing costs in the economy which influences interest rates for loans, mortgages, and savings

How does the Federal Fund Rate work?

Banks are required to have certain amount of money stored

once reserves are too large banks will lend excesses to other banks with low reserve funds (the rate of these transactions is FFR)

What is the main impact of FFR

It can change the availability of credit

What will happen when FFR rates are high?

It discourages borrowing and spending (slows down inflation and economic activity

What happens when FFR rates are low?

Encourages borrowing and spending

How can cost of borrowing curb inflation for FFR?

If fed raises FFR borrowing cost for banks increases —> these costs are passed to consumers through high interest rates for loans and credit

When borrowing costs are high people spend less which lowers demand in the economy

When used to curb inflation, how does FFR impact investments?

Businesses are less likely to invest in new projects or hire due to high costs which slows economic growth

When used to curb inflation, how does FFR change management and expectations of inflation for businesses?

If fed raises interest rates it could equal that they expect inflation to come down in the future

If inflation is thought to come down businesses will adjust behavior —> companies may not raise prices right away and workers may not expect wage increases

How can FFR strengthen currency when used to combat inflation?

If rates are high, more foreign investors are draw towards US assets (greater potential for high return due to high rates)

If demand for these high rate assets increases, the power of the dollar strengthens

A stronger dollar can make imports cheaper because of the increases in purchasing power

CHeaper imports could mean cheaper prices on goods or stabilized prices

What are coupon bonds?

Bonds paying periodic interest to the holder

holder receives par value of bond plus payments made when maturity hits

What are discount bonds?

Bonds sold at a discount or lower cost than its par value

return comes from difference between price and value at maturity

What is Yield to Maturity?

an equation that calculates the total return on a bond if held to maturity

Yield to Maturity Equation

P = 1 / (1 + r)^T

P = Current Price of Bond

r = YTD

T = time to maturity

What are real interest rates?

Rates that adjust nominal rates for inflation which reflects the true purchasing power overtimes

What is leveraging?

Involves borrowing money to invest in assets which amplifies risk but also returns