Question

The main interest rate that the Federal Reserve tries to control is the Federal Funds rate,...

The main interest rate that the Federal Reserve tries to control is the Federal Funds rate, the interest rate that banks charge on short-term (usually overnight) loans to other banks. Let’s see how much interest a bank can earn if it lends money at the Federal Funds rate.

Virginia Community Bank has $2,000,000 of extra cash sitting in its account at the Federal Reserve Bank of Richmond. It gets a call from Bank of America asking to borrow the whole $2,000,000 for 24 hours. (This is typical: It’s usually the smaller banks lending money overnight to the bigger banks.)

a. If the annual interest rate on federal funds is 4%, what (approximately) is the one-day interest rate on federal funds?

One day interest rate:______%

How many dollars of interest will Virginia Community Bank earn for lending this money for one day?

Interest earned on one-day loan: $_____

If Virginia Community Bank lent this amount every day at the same rate for an entire year, how much interest would it earn?

Interest earned on one-year loan: $_____

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Answer #1

To convert annual interest rate to a daily interest rate based on simple interest, we simply divide the annual interest rate by 365, the number of days in a year.

a. If the annual interest rate on federal funds is 4%,

The one day interest rate = 4/365 = 0.0109589%

Interest earned on one-day loan of $2,000,000 = 0.0109589/100×2,000,000 = $219.178

If Virginia Community Bank lent this amount every day at the same rate for an entire year,

Interest earned on one-year loan = 219.178×365 =$80,000

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