The federal funds rate is the interest rate at which financial institutions lend each other money through the mechanism of the Federal Reserve. We all know that the Fed “sets” the federal funds rate. But according to this Wikipedia article, the Fed can only set a target for the rate. Apparently the financial institutions are free to negotiate any mutually agreeable rate.
How, then, can the Fed really influence interest rates? In other words, why would banks agree to something other than the market-clearing interest rate just because the Fed wants them to? Also, supposing there is some way the Fed can coerce banks to do business only at the Fed’s target rate, if the Fed’s target is different from the market-clearing interest rate, wouldn’t this depress the money supply by discouraging lending? In other words, I have a trillion dollars on deposit at the Fed, but I don’t want to lend it at the Federal Funds Rate. So I just sit on it and hope that the rate will go up, or I use it for some other, more profitable purpose.