Discount Rate vs Interest on Reserve Balances (IORB)
Discount Rate and Interest on Reserve Balances (IORB) 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. 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.
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.
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.
Discount Rate vs IORB: The Rate the Fed Charges and the Rate It Pays
| Discount Rate | Interest on Reserve Balances (IORB) | |
|---|---|---|
| Direction of the payment | The bank pays the Fed for a loan | The Fed pays the bank on a balance it already holds |
| Which edge of the corridor | The upper edge, capping how high the overnight rate can go | The lower edge, setting the least a bank will accept to lend reserves |
| What using it takes | An application, eligible collateral, and a willingness to be seen borrowing | Nothing at all, since every reserve balance earns it automatically |
| How much is used on a normal day | Very little, because market funding is cheaper | Every reserve balance in the system, every day |
| Effect on the quantity of reserves | Borrowing at the window creates reserves the bank did not have | Pays a return on reserves that already exist |
| Ordering constraint | Must be set above the rate paid on reserves | Must sit below the discount rate, or borrowing to redeposit turns a profit |
| Reach of a change | Narrow, touching only the reserves banks choose to borrow | Wide, changing the outside option for every dollar a bank could lend |
The discount rate has to sit above the rate paid on reserves, or the window becomes a money machine
Suppose the rate paid on reserve balances is an illustrative 2.40 percent and the discount rate is 2.75 percent. A bank that borrowed at the window purely to redeposit the proceeds would pay 2.75 and earn 2.40, losing 0.35 percentage points for the trouble, so nobody does it and window borrowing stays what it is meant to be, a response to an actual shortfall. Now flip the two and set the discount rate at 2.25 percent against a reserve rate of 2.40 percent. The identical round trip now earns 0.15 percentage points with no credit risk and no effort. On $600 held for a year that is $0.90, small in isolation and irresistible once it scales with every dollar of collateral a bank can pledge. Any bank would borrow to the limit and lend to nobody. Central banks therefore price the window above the reserve rate by design, and back the pricing with collateral rules and the expectation that discount credit answers liquidity needs. That ordering is also what makes the corridor: no bank lends reserves for much less than the central bank pays it, and no bank pays much more than the window charges.
Changing one moves every reserve balance, changing the other moves almost none
Reach is where the two tools stop being comparable. The rate on reserve balances applies to every dollar of reserves in the system at once, so raising it raises what a bank earns for doing nothing. Lending to a firm now has to beat a better risk free alternative, marginal loans stop being worth making, banks keep more reserves idle, and deposit creation slows across the whole system. The realized money multiplier falls without the required ratio changing at all. A change in the discount rate touches only the reserves banks actually borrow from the central bank, which on an ordinary day is a small share of the total, so the move works mostly as a signal about the direction of policy and as an adjustment to the ceiling of the corridor. That difference explains a split students notice in their reading. Older treatments list the discount rate among the main levers over the money supply, because they describe a system where reserves were scarce and window borrowing mattered. Descriptions of how the overnight rate is held inside its target range today point instead at the rate paid on reserves. Both are true of the systems they describe.
Frequently asked questions
Is the discount rate the same as the interest rate paid on reserves?
The discount rate and the rate paid on reserve balances are two different administered rates that run in opposite directions. Banks pay the discount rate when they borrow reserves from the central bank, and the central bank pays the reserve rate to banks that leave reserves sitting with it. One is the price of getting reserves, the other is the return on keeping them, and the gap between the two forms the corridor the overnight market trades inside.
Why must the discount rate be higher than the rate paid on reserves?
Setting the discount rate below the rate paid on reserves would let a bank borrow from the central bank and immediately redeposit the money there for a risk free spread, repeating the trade for as long as its collateral held out. Pricing the window above the reserve rate removes that incentive completely, so borrowing at the window makes sense only when a bank genuinely needs funds and cannot get them more cheaply elsewhere. The ordering is a design rule rather than a coincidence.
Which of the two has more effect on bank lending?
The rate paid on reserve balances has the wider reach, because every reserve balance earns it and a change alters what a bank gives up by making a loan instead of holding reserves. Raise it and idle reserves compete better against lending, so credit growth and deposit creation slow across the entire system. A discount rate change touches only the small share of reserves that banks borrow from the central bank on a normal day, so its immediate effect is closer to a signal than a squeeze.
Live Money Market graph. Drag the curves, or open the full version.
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