We have been trading fed funds between banks and possibly setting their interest rate. Now, we will examine the broader context of these interest rates. This will help us understand the other roles that the Federal Reserve plays beyond just facilitating payments between banks.

The interest rate of a fed funds loan is determined through open market negotiations between borrower and lender banks. When two banks agree on a rate, it is based on factors such as the size of the borrower bank's liabilities and the lender bank's willingness to lend or its need to reduce excess reserves. If the borrower bank has high exposure, the lender bank may increase the interest rate offered. Conversely, if the lender bank is confident in the borrower bank's business, it may offer a lower rate.

The Effective Federal Funds Rate (EFFR) is calculated by finding the volume-weighted median rate of all fed funds loans traded between banks. This rate is determined by taking the median of the interest rates of loans traded at the midpoint of the total money traded in a day. The St Louis Fed gives the following example...

"For example, assume that on a given day, $10 billion of federal funds transactions occurred at each of 5, 10, 15 and 20 basis points, and $60 billion occurred at 25 basis points. This represents $100 billion of total volume. The median would be the rate at the ‘middle dollar’, or $50 billion, which is 25 basis points in this example."

It is important to understand the Effective Federal Funds Rate for two reasons. Firstly, it helps us to assess the health of the banking system. A low EFFR may indicate that the economy is growing too quickly, and is at risk of inflation, whereas a high EFFR may suggest that the economy is slowing down and is in danger of recession. Secondly, it allows the Federal Reserve to gain an overview of the payment system, so that it can intervene in the market to restore balance. In the next chapter, we will explore how the Fed can adjust the EFFR by using the 'Target Rate'.