Federal funds rate can be described as a target interest rate which is set by the Federal Open Market Committee (FOMC) and it is the interest rate at which excess reserves of commercial banks are lent to and borrowed from each other overnight.
The law requires that commercial banks must maintain certain percentage of their deposits in their account with Federal Reserve bank as a reserve. When there is an excess of money above the required level in the reserve of some banks, the excess can be lent by those banks to other banks that have shortfalls. The interest rate that is paid by the borrowing banks is the federal fund rate.
The Fed sets a reserve requirement that banks must keep with them out of their deposits. Everyday they will have to meet this reserve requirement. When they do not, they have the option to borrow overnight from another bank that has excess reserves.
The rate that they will borrow these excess reserves at is the Federal Funds Rate. This rate is set by the Federal Open Market Committee (FOMC) of the Fed which does so based on the economic condition of the nation.
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