Tuesday, August 30, 2022

Coffee and Pastry Shops Avoid Inflation Backlash Punishing Restaurants

Nation’s cafes benefited in June as patrons returned to the office and hung on to their favored indulgences

By Rina Torchinsky of The WSJ. Excerpts:

"Americans dined out less as inflation surged this summer, but couldn’t resist shelling out more at coffee and pastry shops.

Total consumer spending fell 3.1% in June from a year earlier at the restaurants analyzed in a report by the financial-services provider Rabobank using data from Earnest Research. But spending at coffee shops and bakery cafes rose 1.9% during the period, the report said.

Analysts, economists and coffee drinkers offer varied explanations for the resilience of caffeine and sugar suppliers, including the pleasure of relatively small indulgences during a time of belt-tightening."

[One coffee drinker said] "“It’s not really going to eat into my budget if I’m just going every once in a while,”" [when the share of your budget spent on a good is low, its price elasticity of demand will be low so that for any given price change quantity demanded will not change much]

"Many consumers are hooked on their routines as much as the stimulants"

"Some analysts said the relative health of coffee and pastry purveyors in June could be a reflection of the return of more workers to offices. “The basic hypothesis is that when you commute, you will buy more in coffee shops,” said David Tinsley, senior economist at Bank of America Institute. “You’re quite likely to buy one going into work. You’re quite likely to buy your lunch or another cup of coffee in the afternoon.” 

The average price of a cup of a coffee in a quick-service shop was $4.90 in the first six months of this year, up 7.6% from the same period last year" [if they are saying that coffee costs 7.6% more than 12 months ago, then that is pretty close to the overall inflation rate so we would not expect sales or quantity demanded to be affected too much]

"Brewing at home was more expensive, too. The price of coffee increased 15.8% in June from a year earlier and rose 20.3% in July, according to the Labor Department." [if coffee you brew at home is a substitute for coffee from a shop then when the price of store bought coffee increases the demand for a substitute will increase. That would help explain why the coffee shops are doing okay]

"Alfredo Romero, economics professor at North Carolina Agricultural and Technical State University, said, “There are some things that people are slower to let go of, and one of those things is coffee.”" [that could be consistent with the earlier statement about people being hooked on stimulants which would mean that there are not many good substitutes for coffee and goods with few substitutes have a low price elasticity of demand]

Monday, August 29, 2022

The Surprise in a Faltering Economy: Laid-Off Workers Quickly Find Jobs

People losing jobs are rapidly landing interviews, multiple job offers and higher pay, holding down unemployment totals

By Sarah Chaney Cambon of The WSJ. Excerpts: 

"But one characteristic of today’s economy is that job cuts at small startups and large companies have yet to dent the overall labor market. Labor demand is still historically strong, offering only faint signs of cooling. There are nearly two job openings for every unemployed person seeking work. That means many workers who are losing their jobs are quickly landing jobs. Some are even weighing multiple offers and accepting positions that pay more and better align with their skills.

“With unemployment so low, job openings so high and the quits rate so high, we’re finding that the balance of power is still with the job seeker,” said Paul McDonald, senior executive director at staffing firm Robert Half.

Initial jobless claims, the number of applications for state unemployment benefits, have risen this summer after hitting a half-century low in the spring. In the week ended Aug. 13, a seasonally adjusted 250,000 workers filed for benefits, above the 2019 prepandemic average of 218,000 and a sign that layoffs have ticked up.

Meanwhile, continuing claims, a proxy for the number of people claiming ongoing jobless benefits, have increased at a much slower rate. Continuing claims were about 1.4 million in the week ended Aug. 6, below their 2019 average of 1.7 million. Relatively low and stable continuing claims could indicate workers are leaving unemployment rolls quickly as they regain employment, some economists say."

"The typical unemployed worker had been off the job for 8.5 weeks in July, down from 14.4 weeks a year earlier, according to the Labor Department. The shorter duration of unemployment suggests many unemployed Americans are finding jobs fast as fewer leave the labor force, said Julia Pollak, chief economist at ZipRecruiter.

Shorter episodes of joblessness defy economists’ concerns earlier in the pandemic that workers would suffer from long-term spells of unemployment of 27 weeks or more like they did after the 2007-09 recession.

The share of all jobless Americans unemployed for less than five weeks surpassed the share of those out of work for at least 27 weeks in January, according to the Labor Department. The gap has since widened. By July, nearly 37% of unemployed workers had been out of work less than five weeks, roughly double the percentage experiencing long-term joblessness."

"Employers had 10.7 million unfilled jobs in June, down from a record of 11.9 million in March, but still well above the 7 million job openings in February 2020 ahead of the pandemic, when the labor market was also booming.

Job-openings rates across industries are much higher than before the pandemic hit, suggesting companies still need workers even in sectors where company layoffs have been pronounced, such as technology, real estate, finance and insurance.

Longer periods of unemployment can allow job seekers more time to search for roles that match their skill sets, some economists say. But with job opportunities so abundant, many unemployed workers are finding jobs that suit them within a matter of weeks or even days."

Saturday, August 27, 2022

Disney’s New Pricing Magic: More Profit From Fewer Park Visitors

Attendance remains below prepandemic levels, but Disneyland and Disney World are making more money than ever. The company has raised some prices and eliminated or started charging for other services and features that used to be free.

By Robbie Whelan and Jacob Passy of The WSJ. Excerpts:

"These days, Walt Disney Co. DIS -2.89% has a new magic trick: wringing every last dollar out of each visitor to its profitable theme parks."

"The results reflect a major strategic shift on Disney’s part, where the company is focused less on maximizing the quantity of visitors and more on increasing how much money each visitor spends, an approach the company refers to as yield management. Improving the visitor experience, the thinking goes, will prompt guests to spend more hours—and therefore more money—at the parks because they are having such a good time."

"The biggest change in the past two years—and the most lucrative for Disney—is the introduction of a smartphone-app feature called Genie+ that costs $15 per person a day, on top of the price of admission, and allows parkgoers to skip the unreserved lines for some attractions, which the company refers to as “standby.” But Genie+ doesn’t cover everything. To skip the standby lines at the most sought-after attractions, including some Star Wars and Guardians of the Galaxy-themed rides, reservations now cost an additional $10 to $17. Standby waits for popular attractions can last hours.

At the same time, many benefits that used to be free—from parking for certain annual passholders to airport shuttles to MagicBand wristbands that serve as combination hotel-room keys and park passes—have been eliminated or now come with a price."

"Disney’s theme-park pricing is determined by “pure supply and demand,” said a company spokeswoman. “No different than airplanes, hotels or cruise ships.”"

"annual passholders at Disneyland account for about one half of annual visits—but . . . annual passholders tend to spend less than other visitors per visit"

"A typical annual pass holder might ride only one ride during a visit, eat an ice cream cone and walk around for a few hours, taking up capacity that might otherwise be used by out-of-state visitors"

"About half of visitors to the parks pay for and use Genie+"

"of those who pay for Genie+, 70% say in post-visit surveys that they plan to do so again"

"Disney has stopped selling nearly all new annual passes to Disneyland and Walt Disney World and has done away with a host of free perks that annual passholders used to enjoy. Existing annual passholders can renew their passes, although earlier this month, the company raised the renewal price for its highest-tier annual passes to Disneyland by 14%, to $1,599 from $1,399, while at the same time introducing more blackout days when passholders can’t visit"

"The new reservation system has allowed the company to limit attendance without having to turn visitors away when the parks become overcrowded, as it occasionally did in previous years.

The company also points out that it offers frequent promotions, including discounted room rates at its hotels, packages that become more economical the more days a visitor spends at the park, and discounts for residents of Southern California and Florida."

"Some longtime fans who come to the park regularly, and aren’t splurging on once-in-a-lifetime memories, complain about the new fees."

"The Genie+ app feature replaced a system known as FastPass that used to come free with any ticket sold at Disneyland or Walt Disney World. The new service—along with a free version, known simply as Genie—does more than make Disney money: It also helps the parks’ operators direct traffic and spread people around the parks more evenly, to reduce waiting times overall, and upsell visitors by offering them promotions on food, merchandise and ride-reservation fees.

Each park has an operation center with a “heat map” that tracks where Genie+ users are in the parks using GPS technology. Park operators can direct traffic using the app by notifying visitors where the shortest lines are and offering food and merchandise promotions to cajole them to other areas.

“If I’m seeing too much activity on the west side, I’m able to spread where I direct people to the east side,” Mr. D’Amaro said. “Our attractions will be load-balanced better, and lines will be shorter, and what that means is the experience will be better.”

In an analysis for The Wall Street Journal, Touring Plans analyzed room prices, including taxes, at three popular Walt Disney World hotels over the past decade, and found increases that far outpaced inflation, which in July hit a record high of 9.1%."

"Prices for tickets and certain food items have also climbed faster than inflation over the past decade, the Touring Plans analysis found. Disney fan blogs have noted that classic purchases at Disney parks, including the pineapple Dole Whip frozen treat ($5.99 last year, $6.99 this year at some locations) and studded Mickey Mouse-ears headbands ($29.99 last summer, now $39.99) are quickly getting costlier, outpacing inflation."

Thursday, August 25, 2022

James Buchanan, Frank Knight and John Stuart Mill on choice and utility functions

In economics we say that people want to maximize their utility. They buy the combination of goods that will make them happiest.

These three economists had some interesting observations about this.

Frank Knight was an economics professor at The University of Chicago in the first half of the 20th century. John Stuart Mill was a British philosopher and economist in the 19th century.

Here is an interesting quote from Knight followed by a similar one from John Stuart Mill.

"Life is at bottom an exploration in the field of values, an attempt to discover values, rather than on the basis of knowledge of them to produce and enjoy them to the greatest possible extent. We strive to 'know ourselves,' to find our real wants, more than to get what we want"
Source: Knight, Frank H. 1935. "The Limitations of Scientific Method in Economics," in The Ethics of Competition and other Essays. Harper and Row: New York.

See also Frank Knight’s “Risk, Uncertainty and Profit” 100 Years Later: Without Frank Knight, there would not have been a Chicago School of Economics by John Phelan. 

John Stuart Mill said: 

“The purpose of liberty is not to give us what we want but to help us grow so that we can best understand our wants.”

See The Forgotten Philosopher by Alan Wolfe in The Chronicle of Higher Education.

I read something about Nobel Prize winning economist James Buchanan today that reminded me of what Knight and Mill said. See Some Economics of James Buchanan by Timothy Taylor (the post is very interesting, raising questions about what economics is). This excerpt is a quote from Buchanan:

"In one sense, the theory of choice presents a paradox. If the utility function of the choosing agent is fully defined in advance, choice becomes purely mechanical. No "decision," as such, is required; there is no weighing of alternatives. On the other hand, if the utility function is not wholly defined, choice becomes real, and decisions become unpredictable mental events. If I know what I want, a computer can make all of my choices for me. If I do not know what I want, no possible computer can derive my utility function since it does not really exist."  

All of this raises questions about utility functions. Do we have them? Do they change over time? If they do, how and why? 

We say that tastes and preferences are one of the shift factors for demand in economics. If the taste for something increases, then demand increases. But normally we don't say much about why tastes change. 

Mill and Knight both seem to be saying that life is finding out what your tastes are. If that is the case, maybe, like Buchanan says, a computer could not make decisions for us.

Wednesday, August 24, 2022

The Texas High Plains region could generate enough wind energy to power at least 9 million homes but not without significant infrastructure upgrades to transmit it

See Why the Texas grid causes the High Plains to turn off its wind turbines by Jayme Lozano of The Texas Tribune. Excerpts:

"The state’s High Plains region, which covers 41 counties in the Texas Panhandle and West Texas, is home to more than 11,000 wind turbines — the most in any area of the state.

The region could generate enough wind energy to power at least 9 million homes. Experts say the additional energy could help provide much-needed stability to the electric grid during high energy-demand summers like this one, and even lower the power bills of Texans in other parts of the state.

But a significant portion of the electricity produced in the High Plains stays there for a simple reason: It can’t be moved elsewhere. Despite the growing development of wind energy production in Texas, the state’s transmission network would need significant infrastructure upgrades to ship out the energy produced in the region."

"“Because there’s not enough transmission to move it where it’s needed, ERCOT has to throttle back the [wind] generators,” energy lawyer Michael Jewell said. “They actually tell the wind generators to stop generating electricity. It gets to the point where [wind farm operators] literally have to disengage the generators entirely and stop them from doing anything.”"

"wind farms across the state account for nearly 21% of the state’s power generation."

"Wind energy is one of the lowest-priced energy sources because it is sold at fixed prices, turbines do not need fuel to run and the federal government provides subsidies. Texans who get their energy from wind farms in the High Plains region usually pay less for electricity than people in other areas of the state."

"A 2021 ERCOT report shows there have been increases in stability constraints for wind energy in recent years in both West and South Texas that have limited the long-distance transfer of power.

“The transmission constraints are such that energy can’t make it to the load centers. [High Plains wind power] might be able to make it to Lubbock, but it may not be able to make it to Dallas, Fort Worth, Houston or Austin,” Jewell said. “This is not an insignificant problem — it is costing Texans a lot of money.”"

"the Public Utility Commission, which oversees the grid, is conducting tests to determine the economic benefits of adding transmission lines from the High Plains to the more than 52,000 miles of lines that already connect to the grid across the state. As of now, however, there is no official proposal to build new lines.

"“It does take a lot of time to figure it out — you’re talking about a transmission line that’s going to be in service for 40 or 50 years, and it’s going to cost hundreds of millions of dollars,” Jewell said."

"while transmission upgrades across the state have generally been made in a timely manner, it’s been challenging to add infrastructure where there has been rapid growth, like in the High Plains."

Related post:

Texas power companies seek to shift storm prep costs onto consumers (2021)

Some provisions of the new law regulating the Texas power grid (2021)

Companies were paid to cut off power during February storm in Texas (2021) 

Did higher prices keep the power grid going during the recent heat wave? (2018)

CPS Energy uses behavioral science to reduce energy usage during peak times (2017)

We might have enough power in Texas this summer, but rates might be going up to pay for the extra capacity (2022)

Tuesday, August 23, 2022

Electric Camelot: An Economist Visits King Arthur's Court

This is the title of an article that was published recently and was actually in Spanish by Rafael Galvão de Almeida. He is at Universidade Federal de Minas Gerais, Brasil. The title in Spanish is "Camelot Elétrica: Um Economista Visita a Corte do Rei Arthur."

It was published in the journal "História Econômica & História de Empresas" which means "Economic History & Business History." Click here for more information.

Here is the abstract:

"Mark Twain wrote the book A Connecticut Yankee in King Arthur's Court(1889) as a way of reflecting on the changes taking place in the United States of the so-called “Golden Age”. The book tells the story of Hank Morgan, an engineer who ended up in 6th century England, when King Arthur led the Knights of the Round Table in Camelot. Hank attempts to industrialize England twelve centuries earlier, using his knowledge of technology and culture. However, his Electric Camelot project, over numerous setbacks and failure. The novel is relevant to economists because it deals with various topics of interest, such as entrepreneurship and economic development. The literature on the “visiting economist syndrome” identifies numerous problems in a country’s development aid process due to a number of factors, including even the arrogance and naivety of economic models, but that are present when dealing with different contexts. It is argued that these problems were discussed by Mark Twain, who was interested in the nascent neoclassical economics, in the novel in question. Although Hank is an engineer, his trajectory is similar to that of a visiting economist. Thus, the book is a tool to explore through fiction problems and challenges of economic development."

Click here for a link to the entire paper. It is in Spanish.

Related posts:

Related posts:

Chapter 33 Of Mark Twain's A Connecticut Yankee in King Arthur’s Court Is Titled "SIXTH CENTURY POLITICAL ECONOMY" And Deals With "Money Illusion"

Mark Twain On Work And Pay

Mark Twain On Labor Markets And How Wages Should Be Decided-By Government Fiat Or By Markets?

Mark Twain Understood That It Is The Purchasing Power Of Wages That Matters

Mark Twain, Free Trade and Tariffs

Mark Twain, Economist?

Sunday, August 21, 2022

‘The Price of Time’ Review: Getting Interest Rates Wrong

They are the ‘universal price’ at the base of an economy. Keeping rates artificially low has created an addiction with its own cost.

By historian Adam Rowe. He reviews the book The Price of Time: The Real Story of Interest by Edward Chancellor. Excerpts:

"The practice of charging interest is as old as time itself. Before Mesopotamians had learned to coin money or place wheels on carts, lenders had established the practice of demanding more in the future of whatever they made available to borrowers in the present. The etymology of many of the words for interest derive from the offspring of livestock, reflecting an awareness that wealth well managed is fruitful. But the etymology also reflects a suspicion that interest allows the rich to devour the poor. Ancient Hebrew words for interest include one meaning “the bite of a serpent.”"

"From the beginning, Mr. Chancellor shows, rulers have tried to intervene to soften the antagonism between borrowers and lenders. The earliest set of laws, Hammurabi’s code in Babylon (from around 1750 B.C.), is preoccupied with regulating interest—setting maximum loan rates, including 20% for silver and 33.33% for barley. A millennium later, Athens’s renowned lawgiver Solon ordered all the stones recording mortgages destroyed as part of an effort at moral and political renewal. (His predecessor Draco, to whom we owe the word “draconian,” had forced many debtors into slavery.) Thinkers and philosophers throughout history—from Aristotle and Aquinas to Proudhon and Marx—have regarded any rate of interest as unjust. Mere scribblers shared this view. According to Daniel Defoe, “interest of money is a canker-worm upon the tradesman’s profit.”"

"Of proto-capitalist 16th-century England, the historian R.H. Tawney wrote: “The borrower was often a merchant, who raised a loan in order to speculate on the exchanges or to corner the wool crop.” As for the lender, he might well be “an economic innocent, who sought a secure investment for his savings.”"

"Like any other price, the rate of interest reflects a complex balance of forces in the real economy, from aggregate savings to future expectations. When governments push that price too low—or too high—they create distortions that are counterproductive and socially unjust."

"The price of securities tends to rise or fall inversely with the price of interest. Those who own the most securities thus benefit the most when interest rates fall."

"Low interest rates don’t help the poor, who don’t have access to cheap credit. They do help people with formidable assets already, in part by making leverage more attractive. With money so cheap, financiers can boost investment returns with borrowed cash."

"Artificially low rates distort the decentralized decision-making process of a market economy. Without interest, he writes, “capital can’t be properly allocated and too little is saved.” Investors accept more risk in pursuit of higher returns, making future growth seem more attractive than current profits. And because interest is one of the chief costs in finance, low rates shift economic activity from “real world” enterprises to purely financial transactions."

Friday, August 19, 2022

Working from home and the price elasticity of demand for petrol

Interesting post from Michael Cameron, economics professor at the University of Waikato in New Zealand.

He added some great points to a post I did in July called Is the ability to work from home affecting the price elasticity of demand for gas?

Here is an excerpt from Professor Cameron's post:

"How does working from home change this picture? When workers can work from home instead of driving into the office, this makes available a new substitute for driving. Working from home is relatively cheaper than driving, so many workers would prefer to work from home, if they can. That makes demand for petrol more elastic. The change in elasticity will be greatest for workers where working from home is a closer substitute to working in the office. That will include workers who don't have to drive towards work for other reasons, such as dropping kids off at school, grocery shopping on the way home, etc.

The current high price of petrol (as a result of the war in Ukraine, and unrelated to working from home (as far as we know)), has probably reinforced the increase in the price elasticity of demand. If petrol is now taking up a higher proportion of household income, demand will tend to be more elastic for that reason as well.

Combining those effects, demand for petrol is more elastic now than it was before the pandemic led to a large increase in working from home."

Thursday, August 18, 2022

Data Show Gender Pay Gap Opens Early ("Determining why those gaps appear earlier isn’t simple," "There is no neat, tidy explanation")

Disparities among male and female college graduates appeared within three years, a WSJ analysis of federal data for 2015 and 2016 graduates shows

By Melissa Korn, Lauren Weber and Andrea Fuller of The WSJ. Excerpts:

"Broad new data on wages earned by college graduates who received federal student aid showed a pay gap emerging between men and women soon after they joined the workforce, even among those receiving the same degree from the same school.

The data, which cover about 1.7 million graduates, showed that median pay for men exceeded that for women three years after graduation in nearly 75% of roughly 11,300 undergraduate and graduate degree programs at some 2,000 universities. In almost half of the programs, male graduates’ median earnings topped women’s by 10% or more, a Wall Street Journal analysis of data from 2015 and 2016 graduates showed."

"Determining why those gaps appear earlier isn’t simple. The federal data don’t account for such factors as recipients of the same degrees seeking different types of jobs and career paths, some of which pay far more than others. Studies have shown that men tend to negotiate salaries more aggressively than women, and women at times shy away from ambitious goals for fear of being unprepared. Even when women and men have identical academic credentials, women sometimes choose lower-paying career paths, pursuing a passion rather than a high paycheck.

The median pay for men from the California State University, Fullerton, nursing master’s program, for instance, was $199,000 three years after graduation, compared with $115,000 for women. The school said that is largely because women in the program gravitated toward nurse midwifery, which pays less than specialties like anesthesiology.

Researchers also say that discrimination, despite laws against it, remains a factor in the gender pay gap at all career levels."

"Among those with undergraduate degrees, women out-earned men in just four of the 20 most popular areas of study"

"Across those 20 fields, men and women’s pay came closest to parity in economics, where women earned 1.4% more than men. 

“There is no neat, tidy explanation” for the early-pay disparities, said Francine Blau, a Cornell University labor economist.

Researchers say women choosing careers sometimes internalize societal expectations about which jobs suit them. Well-intentioned advisers and employers can steer women toward less lucrative options, based on assumptions about their aspirations.

Graduates of petroleum-engineering programs, among the highest-paying undergraduate majors in the country, often take jobs either as field engineers or data analysts. Career-service advisers and graduates said women are more represented in the latter roles, which are based in an office, involve more regular work hours and can pay less."

"Different job tracks also can explain part of the pay gap at Michigan’s law school, where men earned a median income that was 37% higher than women’s three years out.

The school said that in the classes of 2015 and 2016, 237 men took jobs at law firms, while 158 women did. Fourteen men headed into public-interest jobs, whereas three times as many women did. The classes those years had slightly more men than women.

Several women said in interviews that the mission-driven work appealed to them, outweighing the draw of a higher law-firm salary."

"Several women who graduated from the San Antonio program noted that male classmates launched their own practices—generally a more lucrative path—sooner after graduation than female classmates, who often completed residencies and worked for other dentists before buying or starting a practice."

"Research indicates that women are less aggressive than men in negotiating salaries or raises, worrying they will come across as too demanding. If they don’t do so early on, it can be harder to achieve pay equity later."

Related posts:

It Pays To Be A Male Chauvinist Pig (2008) 

Is there sufficient evidence to conclude that women experience systematic pay discrimination? (2013) 

Do Movies About Women Make A Higher Rate Of Return (2014)  

Do Some Sellers on eBay Have an Edge Over Other Sellers? (Male Sellers on eBay Have an Edge Over Women, Study Finds) (2016)  

The time demands of many jobs can explain much of the gender pay gap (2017)  

In most countries the gender pay gap has decreased in the last couple of decades (2018)  

The EU forbids the use of gender to help calculate car insurance premiums, leading women to pay more and men to pay less (2021)

Tuesday, August 16, 2022

How Does the Fed Use Its Monetary Policy Tools to Influence the Economy? (they don't use open market operations to control the federal funds rate)

"The Federal Reserve sets two overnight interest rates: the interest rate paid on banks' reserve balances and the rate on our reverse repurchase agreements. We use these two administered rates to keep a market- determined rate, the federal funds rate, within a target range set by the FOMC." 

—Jerome Powell, Chair of the Federal Reserve

By Jane Ihrig and Scott A. Wolla of The Federal Reserve Bank of St. Louis

"The Federal Reserve (the Fed) is the central bank of the United States. As the central bank, it serves several key functions within the economy. One of the most important functions of the Fed is to promote economic stability using monetary policy. The Fed's goals for monetary policy, as defined by Congress, are to promote maximum employment and price stability

The Federal Open Market Committee (FOMC) is the monetary policymaking arm of the Federal Reserve. The FOMC usually meets eight times per year in Washington, D.C. These two-day meetings include a review of economic data and financial conditions, briefings by economists, policy discussions, and a vote on the setting of monetary policy—including a decision about whether the FOMC will adjust its target range for the federal funds rate. The federal funds rate is the interest rate banks charge each other for overnight loans. The Fed sets a target range for where it wants the interest rates charged to fall within, and it is the setting of this range that the Fed uses to communicate its monetary policy position.

Figure 1
The Federal Funds Rate Target Range

SOURCE: Board of Governors of the Federal Reserve System via FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=COX8, accessed April 4, 2022. 

The FOMC conducts monetary policy by setting the target range for the federal funds rate. This graph shows the target range, determined by the upper and lower limits, and the effective federal funds rate within the range. 

Over time, as shown in Figure 1,2 the FOMC has moved the target range up and down as it steers the economy toward maximum employment and price stability. For example, once the economy recovered from the global financial crisis, the FOMC moved the target range from near zero at the end of 2015 up to 2¼ -2½ percent by early 2019. Then when the COVID-19 pandemic hit, the FOMC quickly moved the target range back to near zero.

What Is the Federal Funds Rate and Why Is It So Important? 

The federal funds rate is a very specific short-term interest rate. It involves the transfer of funds between banks that maintain accounts (deposits) with their Federal Reserve Bank; the accounts are called reserve balance accounts. The federal funds market is where banks that may need money in their reserve accounts for cashflow reasons go to borrow from banks that have excess funds in their reserve accounts. Banks who lend funds act as suppliers of reserves in the federal funds market; banks who borrow funds act as demanders of reserves in the federal funds market. The federal funds rate is not "set" by the Fed, but rather determined by the borrowers and lenders in the federal funds market. 

Monetary policy is transmitted through market interest rates to affect consumers' and producers' spending decisions, which ultimately moves the economy toward the Fed's objectives—maximum employment and stable prices. This monetary policy implementation framework ensures that when the FOMC changes its policy stance (raises or lowers the target range for the federal funds rate), market interest rates and financial conditions move in the desired direction.

The FOMC conducts monetary policy by setting the target range for the federal funds rate (Figure 2, Box 1). Then the Fed implements policy by using its monetary policy tools to ensure the federal funds rate stays within the target range (red arrow).

The federal funds rate is important because when the FOMC sets its target range, it influences many other interest rates in the economy (Figure 2, Box 2). In fact, by adjusting the target for this rate, the Fed can influence the spending choices of consumers and producers (Figure 2, Box 3) and ultimately move the economy toward maximum employment and price stability (Figure 2, Box 4).


The Fed's Monetary Policy Implementation Toolbox

The Fed uses its monetary policy tools in the implementation phase. In all, the Fed uses four key tools to help ensure the federal funds rate stays within the target range set by the FOMC.3 We'll use a simple supply and demand model (Figure 3) to describe how the tools work together. Overall, these are the critical tools the Fed uses because reserves in the banking system are ample. That is, the supply of reserves, set by the Fed, is large enough that it intersects the demand curve where it is nearly flat (see Figure 3).

In the ample-reserves framework, the Federal Reserve raises (lowers) its administered rates to move the federal funds rate higher (lower). Small shifts of the supply curve have little or no effect on the federal funds rate.

The Fed's Primary Tool: Interest on Reserve Balances

Today, the Fed's primary tool for adjusting the federal funds rate is interest on reserve balances. The interest on reserve balances rate (labeled "IORB rate" in Figure 3) is the interest rate paid on funds that banks hold in their reserve balance account at a Federal Reserve Bank. For banks, this interest rate represents a risk-free investment option. Importantly, the interest on reserve balances rate is an "administered rate," which means it is set by the Fed and not determined in a market (like the federal funds rate is). In fact, there are two key concepts that ensure interest on reserves is an effective tool. 

The first concept is the reservation rate, which is the lowest rate that banks are willing to accept for lending out their funds. Banks can deposit their funds at the Federal Reserve and earn the interest on reserve balances rate. Because depositing funds at the Fed is a risk-free option, banks will likely not be willing to lend their funds in the federal funds market for a lower interest rate than they can earn from depositing their funds at the Fed. So, the interest on reserve balances rate serves as a reservation rate for banks.

The second concept is arbitrage, which is the simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price. For example, let's assume reserves are trading in the federal funds market at 2 percent (i.e., the federal funds rate is 2 percent) and that reserves (deposits) at the Fed earn 2.5 percent (i.e., the interest on reserve balances rate is 2.5 percent). Banks will quickly see that they can borrow funds in the federal funds market at 2 percent and deposit those funds at the Fed and earn the interest on reserve balances rate of 2.5 percent, which means that they can earn a profit of 0.5 percent (the difference between the rates).The increase in demand for funds in the federal funds market will put upward pressure on the federal funds rate, and the federal funds rate will rise toward the interest on reserve balances rate. This upward pressure on the federal funds rate will continue until the federal funds rate has risen to the level that banks no longer see the opportunity to profit. 

So, arbitrage ensures that the federal funds rate does not fall far below the interest on reserve balances rate. Arbitrage is the reason why these short-term rates remain closely linked. In fact, arbitrage is what makes interest on reserve balances an effective tool for guiding the federal funds rate. Because the Fed sets the interest on reserve balances rate directly, the Fed can steer the federal funds rate down or up by lowering or raising the level of the interest on reserve balances rate. As a result, interest on reserve balances is the Fed's primary tool for adjusting the federal funds rate, but the Fed has other tools that play supporting roles.


Setting a Floor for the Federal Funds Rate: The Overnight Reverse Repurchase Agreement Facility

Interest on reserve balances is available only to banks and a few other institutions. The Fed has an overnight reverse repurchase facility that is open to a broader set of financial institutions. This facility allows these financial institutions to deposit their funds at a Federal Reserve Bank and earn the overnight reverse repurchase agreement rate offered by the Fed. The overnight reverse repurchase agreement rate (labeled "ON RRP rate" on Figure 3) works for these institutions similar to the way the interest on reserve balances rate works for banks. So, this rate acts like a reservation rate for these financial institutions, and the overnight reverse repurchase agreement rate interacts with other short-term market rates through arbitrage. The overnight reverse repurchase agreement facility is a supplementary tool because the rate the Fed sets for it helps set a floor for the federal funds rate (Figure 4).

Figure 4
Steering the Federal Funds Rate

SOURCE: Federal Reserve Bank of New York and Board of Governors of the Federal Reserve System via FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=LP47, accessed April 4, 2022. 

The Fed implements monetary policy by using its monetary policy tools, such as the interest of reserve balances rate (red) and overnight reverse repurchase agreement rate (blue), to ensure interest rates are consistent with the federal funds rate target. 

Setting a Ceiling for the Federal Funds Rate: The Discount Window

The discount rate is the rate charged by the Fed for loans obtained through the Fed's discount window. Because banks will not likely borrow at a higher rate than they can borrow from the Fed, the discount rate acts as a ceiling for the federal funds rate: It is set higher than the interest on reserve balances rate and the overnight reverse repurchase agreement rate (Figure 5).

When the Federal Reserve lowers its administered rates, the end points of the demand curve shift down. The vertical supply curve is unchanged. The demand curve intersects the supply curve at a lower federal funds rate. In general, the Fed tends to lower all the administered rates by the same amount, keeping the spread between the rates constant.


The Final Tool: Open Market Operations

As noted above, the Fed's current method for implementing monetary policy relies on banks' reserves remaining "ample." So, if the Fed needs to add reserves to ensure they remain ample, it does so by buying U.S. government securities in the open market. This action is known as open market operations. When the Fed buys securities, it pays for them by depositing funds into the appropriate banks' reserve balance accounts, adding to the overall level of reserves in the banking system. As Figure 3 shows, open market operations can be used to shift the supply curve left or right. Prior to 2008, open market operations were the Fed's primary monetary policy tool, which it used daily to make sure the federal funds rate hit the FOMC's target. Today this tool is mainly used to ensure that reserves remain ample.

Now that you understand the Fed's implementation tools, let's see how the Fed uses them to achieve its two goals: maximum employment and price stability.


Expansionary Monetary Policy Using the Fed's Tools

Suppose the following: The economy weakens, with employment falling short of maximum employment, and the inflation rate has been steady at around 2 percent but is showing signs of decreasing. The FOMC might decide to conduct monetary policy by lowering its target range for the federal funds rate. To implement that monetary policy, it would decrease its administered rates—the interest on reserve balances rate, overnight reverse repurchase agreement rate, and discount rate—to ensure the market-determined federal funds rate stays within the target range (see Figure 5). These actions would transmit to other interest rates and broader financial conditions:

  • Lower interest rates decrease the cost of borrowing money, which encourages consumers to increase spending on goods and services and businesses to invest in new equipment.
  • The increase in consumption spending increases the overall demand for goods and services in the economy, which creates an incentive for businesses to increase production, hire more workers, and spend more on other resources.
  • As these increases in spending ripple through the economy, likely moving the unemployment rate down toward its full employment level, inflation could possibly move up.

So, the Fed's monetary policy implementation tools can be effective for moving the economy back toward maximum employment and price stability when the economy is stalling.


Contractionary Monetary Policy Using the Fed's Tools

Suppose the following: The economy is showing signs of overheating, with the unemployment rate very low and businesses finding it hard to fill jobs, and the inflation rate has been above the Fed's 2 percent target for quite some time and is rising. In this case, the FOMC might decide to conduct monetary policy by raising its target range for the federal funds rate. To implement that monetary policy, it would increase its administered rates—the interest on reserve balances rate, overnight reverse repurchase agreement rate, and discount rate—to ensure the federal funds rate stays within the target range. These actions would transmit to other interest rates and broader financial conditions:

  • Higher interest rates increase the cost of borrowing money and raise the incentive to save, which dampens consumer spending on some goods and services and slows businesses' investment in new equipment.
  • The decrease in consumption spending decreases the overall demand for goods and services in the economy, which will likely lead to a decrease in production levels, fewer employees hired, and less spending on other resources.
  • As these decreases in spending ripple through the economy, demand for workers could lessen, inflationary pressures would diminish, and the inflation rate would fall back toward 2 percent.

So, higher interest rates can be used to move the economy back to maximum employment and price stability when the economy is overheating.


The Fed has a congressional mandate of maximum employment and price stability. The FOMC conducts monetary policy by setting the target range for the federal funds rate. Then the Fed uses its monetary policy tools to implement the policy, which guides market interest rates toward the Fed's desired setting of policy. The Fed ensures there are ample reserves in the banking system and uses its administered rates to steer the federal funds rate into the FOMC's target range: Interest on reserve balances is the Fed's primary tool for adjusting the federal funds rate; the overnight reverse repurchase agreement facility is a supplementary tool that sets a floor for the federal funds rate; and the discount rate serves as a ceiling for the federal funds rate. Changes in the federal funds rate are transmitted to other interest rates through arbitrage and affect the decisions of consumers and businesses. Their decisions ultimately move the economy toward maximum employment and price stability.


1 Powell, Jerome. "Data-Dependent Monetary Policy in an Evolving Economy." Board of Governors of the Federal Reserve System, October 8, 2019; https://www.federalreserve.gov/newsevents/speech/powell20191008a.htm

2 The effective federal funds rate is the rate used in the figures in this article. On any given day, there are many transactions that settle at slightly different federal funds rates. The effective federal funds rate is the volume-weighted median rate of these transactions.

3 The Fed recently introduced two repurchase agreement (repo) backstop tools, the standing overnight repo facility and the foreign and international monetary authorities repo facility. These are used by specific counterparties to help set a ceiling on repo rates. We do not discuss them here because this article is targeted toward a principles of economics audience.

© 2022, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.


Arbitrage: The simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price.

Discount rate: The interest rate charged by the Federal Reserve to banks for loans obtained through the Fed's discount window.

Facility: A standing program targeted at a set of counterparties for depositing or lending. The Fed has permanent facilities (like the discount window and the overnight reverse repurchase agreement facility) as well as temporary facilities (like those implemented during the Financial Crisis of 2007-09 and the COVID-19 pandemic).

Federal Open Market Committee (FOMC): A Committee created by law that consists of the seven members of the Board of Governors; the president of the Federal Reserve Bank of New York; and, on a rotating basis, the presidents of four other Reserve Banks. Nonvoting Reserve Bank presidents also participate in Committee deliberations and discussion.

Maximum employment: The highest level of employment that an economy can sustain while maintaining a stable inflation rate.

Open market operations: The buying and selling of government securities through primary dealers by the Federal Reserve. When the securities are bought or sold, reserves in the banking system are increased or decreased, respectively.

Price stability: A low and stable rate of inflation maintained over an extended period of time.

Reservation rate: The lowest rate of return that banks are willing to accept for lending out funds.

Reserve balances (reserves): The deposits a bank maintains in its account with a Federal Reserve Bank."