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 is the one-day interest rate on federal funds? (Interest rates, like GDP growth rates, are usually reported as “per year,” just as speeds are reported as miles “per hour.”)
b. How many dollars of interest will Virginia Community Bank earn for lending this money for one day?
c. If Virginia Community Bank lent this amount every day at the same rate for an entire year, how much interest would it earn?