Discount Rate vs Federal Funds Rate
Discount Rate and Federal Funds Rate are two Money & Monetary Policy concepts in AP Economics that students often mix up. The discount rate is the interest rate the Federal Reserve charges commercial banks that borrow from it directly for the short term. The federal funds rate is the interest rate at which banks lend their excess reserves to other banks overnight. Here is how they compare side by side.
When the Fed lowers the discount rate, it becomes cheaper for banks to borrow, encouraging more lending and increasing the money supply. Raising the discount rate has the opposite effect, tightening monetary policy. It is one of the Fed's tools to influence economic activity.
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.
Discount Rate vs Federal Funds Rate: Who Lends, and Who Sets the Number
| Discount Rate | Federal Funds Rate | |
|---|---|---|
| Who is lending | The Federal Reserve lends reserves directly to a commercial bank at the discount window. | One commercial bank lends its own excess reserves to another bank overnight. |
| How the number is chosen | Administered. The Fed announces the rate and that is exactly what a borrowing bank pays. | Market determined. The Fed announces a target range and steers the traded rate into it. |
| Where it sits | At or above the top of the federal funds target range, so it acts as a ceiling and a mild penalty. | Inside the target range, and normally a few tenths of a point below the discount rate. |
| Collateral and stigma | Loans are collateralized, and banks avoid the window because using it can look like distress. | Lending is unsecured and routine, with no signal attached to borrowing there. |
| How much is borrowed | Little in normal conditions, spiking when a bank cannot raise funds anywhere else. | Continuous. Most reserve shortfalls are covered here first, every night. |
| Role in an exam answer | A tool. 'The Fed lowered the discount rate' names an action the Fed took. | An outcome. The rate that action is meant to move, and the rate quoted as the stance of policy. |
The Fed sets the discount rate outright and only aims at the federal funds rate
The discount rate is a posted price. When the Fed approves a primary credit rate of 3.50 percent, every eligible bank that pledges collateral at the window pays 3.50 percent, and no bargaining changes it. The federal funds rate is not posted by anyone. Banks holding reserves at the end of the day lend to banks that are short, and the rate that clears those trades is an average of many private bargains. What the Fed publishes for federal funds is a target range, say 3.00 to 3.25 percent, plus the administered rates it uses to hold the traded rate inside that range. So one rate is a decision and the other is a result. That difference is why a question asking which rate the Fed sets directly has a single answer, the discount rate, even though the federal funds rate is the one every headline quotes as the Fed's interest rate.
The discount rate works as a ceiling, which is why almost nobody pays it
Put numbers on the corridor. Suppose the target range for federal funds is 3.00 to 3.25 percent, the traded federal funds rate is 3.10 percent, and the primary credit rate at the discount window is 3.50 percent. A bank that needs 9 million dollars of reserves overnight can call another bank and pay 3.10 percent, or go to the window and pay 3.50 percent. The gap of 0.40 percentage points on 9 million dollars for one night costs about 100 dollars, and the reputational cost of being seen at the window is larger still. So the bank borrows in the market. The discount rate still matters, because it caps how high the federal funds rate can climb. If banks were desperate enough to bid federal funds above 3.50 percent, borrowing from the Fed would be cheaper and the bidding would stop. A rate almost nobody pays can still set the boundary the market trades inside.
One of these rates is what the Fed changed, the other is what changed as a result
A cut in the discount rate makes it cheaper for banks to borrow reserves from the Fed, so reserves in the banking system rise, the money supply shifts right, the nominal interest rate falls, interest-sensitive investment rises, and aggregate demand shifts right. The federal funds rate belongs in the middle of that chain, as the short-term rate that falls, not at the start as something the Fed changed by decree. Writing that the Fed lowered the federal funds rate compresses two steps into one and can cost the point that asks for the mechanism. Safer phrasing is that the Fed lowered its target for the federal funds rate, or that the Fed lowered the discount rate, which pushed the federal funds rate down. The reverse question works the same way. If a prompt says the federal funds rate rose, treat that as evidence about policy or reserve conditions, then work forward to investment and output.
Frequently asked questions
Why is the discount rate higher than the federal funds rate?
The discount rate is deliberately set above the traded federal funds rate so the window is a backstop rather than a first choice. If borrowing from the Fed were the cheapest option, banks would stop lending reserves to each other and the interbank market would thin out. Pricing the window at a small penalty, for example 3.50 percent against a traded federal funds rate of 3.10 percent, keeps everyday funding in the private market while guaranteeing that no bank holding good collateral is ever stranded.
Does the Federal Reserve set the federal funds rate directly?
The Federal Reserve sets a target range for the federal funds rate, not the rate itself. Banks negotiate the actual rate with each other overnight. The Fed holds that traded rate inside its range using administered rates it does control, including the discount rate as an upper boundary and the rate it pays on reserve balances as a floor. For an exam answer, say the Fed changed its target and then name the tool used to hit it.
Which rate should I name when a question asks about the stance of monetary policy?
Monetary policy stance is normally described with the federal funds rate, because that is the short-term rate the Fed steers and the one that feeds into other borrowing costs. Name the discount rate when a question asks what the Fed changed, and name the federal funds rate when it asks what happened to interest rates. A complete answer often uses both, in that order.
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