Your question is an interesting one--and one that I'm sure many people
share. The basics of how the Federal Reserve System works isn't that
hard to understand.
Essentially, banks lend money from deposits they have taken. Mortgage
companies (and those companies who dont take deposits) lend money
they take in and pool together from individual and corporate
investors. Banks and other lenders do NOT directly lend out money from
the Federal Reserve System.
Net transaction accounts
1 $0 million$41.3 million 3% since 12/27/01
2 More than $41.3 million 10% since 12/27/01
3 Nonpersonal time deposits 0% since 12/27/90
4 Eurocurrency liabilities 0% since 12/27/90
It should be noted that there are exemption amounts under which
there is a zero reserve fund ratio. Currently it is $6 million. For
more information on the ratio, and the current numbers, visit the
Monetary Policy, Reserve Requirements of the Reserve Board website at
As for how raising or lowering effects the banks rate, imagine that
you want to loan someone $100. You got that $100 from someone else who
is charging you 6%. Youd probably want to lend it out at a higher
interest rate than what YOU are payingmaybe 8%. The 2% difference is
Now, as I mentioned, the banks dont loan out the Reserves money
directlyso, the question is why is there a difference to the banks?
Well, since banks are required to keep 10% of their assets in reserve,
and they are constantly putting out money in the forms of loans and
mortgages, there are occasions where the BANK needs a loan to cover a
particularly large withdrawal or otherwise. The bank may not actually
have the money to cover the withdrawal and simultaneously keep 10% in
the reserve fund. Hence, it will borrow the money from the Reserve
(at the Reserves interest rate) overnight until it can get the money
from the sale of stock, securities, other deposits, payments on loans,
etc.. This overnight loan costs the bank moneythe interest on the
Lets assume that the bank puts out all 90% of available funds.
Theyll charge an amount MORE THAN the Reserves rateto hedge their
bet against having to have an overnight loan as a result. So, to go
back to our discussion earlier about YOU loaning $100 to a friend at
8%, if you needed the $100 to pay a bill at 18% interest, and you
borrowed the $100 at 6%, and NEW funds could be gotten from the
original friend at 4%, youd hedge the $100 @ 6% against the 18% bill
in hopes of getting the 4% loan.
Banks do the same thing. They take money at one rate, sell at another,
and have backup loans available to them if needed. Since most banks
will try to sell all their excess money (that is, theyll only keep
the 10% on reserve), as the Reserve raises THEIR rates, so to must the
banks to ensure that they always have enough margin on their loans to
There are a few sites that you may wish to visit that have more
information on the Federal Reserve System in the USA.
That Money Show One Minute MBA The Federal Reserve Board
A quick and dirty primer on the Federal Reserve System
An EXCELLENT source of information that explains how the Federal
Reserve System works.
The Federal Reserve the central bank of the United States
Contains links and resources to other sites about the Federal Reserve
I hope this answers your question. If you should find that you still
have questions, please ask for clarification prior to rating and
closing this question.
how the federal reserve works
federal reserve interest rate
federal reserve ratio