What it is:
How it works/Example:
Banks receive income from loans and it is best for them to loan out as much as possible. But if a "run on the bank" occurs and a large number of depositors suddenly try to withdraw their money, the bank risks failure because it does not have the actual cash to pay all depositors at once. To prevent the chaos that would naturally occur in this situation, the Federal Reserve maintains what is called a fractional reserve banking system. The fractional reserve banking system requires banks to keep a certain percentage of their deposits liquid to accommodate a normal number of withdrawals from depositors at given time.
When a bank cannot meet reserve requirements, it can get a Federal Funds loan. These loans are unsecured and are for very short periods (typically overnight).
An increase in the overnight rate discourages banks from borrowing to meet reserve requirements. This, in turn, encourages them to retain more reserves and lend out less money. A reduction in the overnight rate has the opposite effect: it encourages banks to borrow to meet reserve requirements making more money available for lending. Because the increase in the supply of funds available for lending puts downward pressure on interest rates, changes in the overnight rate can have economy altering effects.
Why it matters:
While the Federal Reserve cannot set the overnight rate, it can control it indirectly. This is primarily done by changing the "discount rate," which is set directly by the Federal Reserve. If the discount rate is lower than the overnight rate, banks would probably rather borrow from the Federal Reserve when they need loans. This puts downward pressure on the overnight rate. On the other hand, if the discount rate is higher than the overnight rate, banks would probably borrow from each other rather than from the Federal Reserve. This puts upward pressure on the overnight rate. In both scenarios, the Federal Reserve can initiate a change in the overnight rate by changing the discount rate. This is why the discount rate and the overnight rate are usually closely correlated.