Banks that have cash in excess of the reserve requirement loan them to banks that are short. The loan is then placed in a Federal Reserve Bank to meet the reserve requirement. The interest rate on the loan is usually pretty close to the target set by the FOMC at its monthly meeting. This is known as the Fed Funds rate.
The reserve requirement is set by the Federal Reserve to control the amount of money available to lend, also known as liquidity. The Fed requires that a certain amount of funds be reserved, or set aside, in the Federal Reserve Bank each night. This is to keep banks from lending out all their money, which they would like to do.
The Fed funds rate target is the interest charged for Fed funds loans. Both the Fed funds rate and the reserve requirement are methods of implementing monetary policy. If the Fed funds rate and reserve requirements are high, this is known as contractionary monetary policy, which decreases liquidity and prevents inflation.
If the Fed funds rate and reserve requirements are low, this increases liquidity. This is known as expansionary monetary policy, and it is used to spur economic growth.
