Federal Funds Rate vs Interest on Reserve Balances (IORB)
Federal Funds Rate and Interest on Reserve Balances (IORB) are two Money & Monetary Policy concepts in AP Economics that students often mix up. The federal funds rate is the interest rate at which banks lend their excess reserves to other banks overnight. Interest on reserve balances (IORB) is the rate the Fed pays banks on reserves held at the Fed; it is now the Fed's main tool for steering the federal funds rate. Here is how they compare side by side.
The Federal Open Market Committee sets a target for this rate to influence borrowing costs across the economy. Changes in the federal funds rate affect consumer and business loans, investment, and overall economic growth. It is the primary tool the Fed uses to implement monetary policy.
Since 2008 the Fed pays interest on reserves, and since 2021 a single IORB rate replaced the separate IORR/IOER rates. Banks will not lend in the fed funds market below what they can earn risk-free at the Fed, so IORB sets a floor that anchors short-term rates in today's ample-reserves system. Raising IORB tightens policy; lowering it eases.
Federal Funds Rate vs IORB: A Market Rate and an Administered Rate
| Federal Funds Rate | Interest on Reserve Balances | |
|---|---|---|
| Who sets it | Trading between banks | The central bank, by announcement |
| What it is paid on | Reserves lent overnight from one bank to another | Reserves a bank leaves sitting at the central bank |
| Type of rate | A market outcome, reported as an average of actual trades | An administered rate, fixed until it is changed |
| Role in policy | The rate the committee targets | The main lever used to hit that target |
| Who can earn it | Any institution able to lend reserves | Only institutions holding accounts at the central bank |
| How it is announced | As a target range, not a single number | As a single number set inside that range |
| When reserves are plentiful | Little interbank borrowing is needed | It anchors the whole structure of short rates |
An administered rate works as a floor because of a simple arbitrage
Suppose the rate paid on reserve balances is an illustrative 4 percent. A bank with spare reserves has an outside option: leave them at the central bank and earn 4 percent with no credit risk and no effort. It will not lend those reserves to another bank at 3.5 percent, because doing so would mean accepting less money and more risk. That single fact puts a floor under the interbank market. The arbitrage runs the other way as well. If some lender of reserves cannot earn the administered rate, it may be willing to lend at 3.9 percent, and a bank that can earn 4 percent will happily borrow at 3.9 and deposit the proceeds. The spread is only a tenth of a percentage point, but on $1 billion held for a year that is $1 million, which is enough to make the trade worth doing. This is also the reason the market rate can settle slightly below the administered rate rather than exactly on it: the set of institutions that can lend reserves is wider than the set that can hold accounts and earn interest on them. Excess balances, described at /glossary/excess-reserves, are the raw material for both sides of this trade.
Which tool steers the target depends on how plentiful reserves are
When reserves in the system are scarce, banks genuinely need to borrow from each other overnight to meet their obligations, and small changes in the total quantity of reserves move the price sharply. In that setting the central bank hits its target by adding or draining reserves through /glossary/open-market-operations, buying securities to push the rate down and selling them to push it up. When reserves are plentiful instead, adding a few billion more changes almost nothing, because nobody is short. Quantity has stopped being a useful lever, so the bank steers with the price it administers directly: raise the rate paid on reserves and every short term rate is dragged up with it, since no bank will accept less elsewhere. The same logic explains why the target is announced as a range rather than a point. Administered rates set the edges, and the market rate is expected to trade somewhere inside. For students the practical takeaway is that the announced rate is a goal and the administered rate is a method, so a question asking how the central bank changes its stance should describe both, as the module at /macro/monetary-policy sets out.
Frequently asked questions
What is the difference between the federal funds rate and IORB?
The federal funds rate is the market rate at which banks lend reserves to each other overnight, while interest on reserve balances is the rate the central bank itself pays banks for leaving reserves with it. One is an outcome of trading and the other is set by announcement.
How does paying interest on reserves control the federal funds rate?
It gives every bank a risk free alternative, so no bank will lend reserves at much less than the rate it can earn by doing nothing. Raising the administered rate therefore pulls the whole overnight market up with it, without the central bank having to change the quantity of reserves at all.
Why can the federal funds rate trade below the rate paid on reserves?
Because some institutions that lend reserves do not hold accounts that earn that interest, so their next best option is worse and they accept a lower rate. Banks that can earn it borrow from them and pocket the difference, and the small spread that survives reflects the limits and costs of doing that trade at scale.
Live Money Market graph. Drag the curves, or open the full version.
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated