Introduction

We have started to comprehend how the banking system is composed of many banks that pretend to be part of one large bank. This is because a healthy bank is able to fulfill its daily obligations, and to ensure this, it is essential that all other banks can do the same. The Clearing House system was introduced to guarantee that banks could meet their daily needs by creating a system in which all debts are owed to the Clearing House and not any individual bank. However, this system can be easily undermined since the Clearing House is ultimately responsible for its members with a limited resource.

The Federal Reserve has the legal authority to create its own liabilities, theoretically meaning it can not run out of money. This makes it easier to facilitate the national interbank payment system. Nonetheless, this does not mean that discipline is not still necessary. The Fed does not provide money without consequences; banks can overdraft with the Fed, but this comes with fees and other associated penalties. To avoid overdrafting, banks will seek loans in the Fed Funds Market to cover their day-to-day operations.

The Fed Funds Market is a system of loans and payments between banks in the federal banking system, and the money is passed between banks in the form of Fed Funds reserves. Lending and borrowing is based on the money each bank has in its account at the fed. This system of lending and borrowing is effectively the expansion and contraction of credit based on the money held on the Federal Reserve's balance sheet. Understanding how the Federal Funds Market works is important in order to gain insight into how banking operates.