Discount Rate vs Reserve Requirement
Discount Rate and Reserve Requirement 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 reserve requirement is the percentage of deposits that banks are legally required to hold as reserves rather than lend out. 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.
When the Fed lowers the reserve requirement, banks can lend more, increasing the money supply through the money multiplier effect. Raising it reduces lending and tightens credit. This tool is rarely changed in modern U.S. monetary policy due to its drastic impact.
Discount Rate vs Reserve Requirement: A Price Versus a Rule
| Discount Rate | Reserve Requirement | |
|---|---|---|
| Type of lever | A price, the cost of borrowing reserves from the Fed | A quantity rule, the share of deposits that cannot be lent |
| Effect on the money multiplier | None, 1 divided by rr is unchanged | Direct, the multiplier is 1 divided by rr |
| Who decides whether it bites | The bank, since borrowing at the window is voluntary | The law, every bank must comply in every period |
| How the expansionary version works | Topping up reserves gets cheaper, so banks hold fewer excess reserves | Each dollar of reserves can support more deposits |
| What changes on a bank's T-account | Nothing until the bank borrows, then reserves rise against a new loan from the Fed | Required reserves fall and excess reserves rise, with total reserves unchanged |
| Frequency of change in practice | Adjusted alongside other policy rate decisions | Rarely touched, taught mainly as a model lever |
| Typical exam question | A directional chain: money supply, interest rate, investment, AD | Arithmetic: excess reserves times 1 divided by rr |
Only the reserve requirement changes the size of the money multiplier
The simple money multiplier is 1 divided by the required reserve ratio, so only one of these two tools appears in the formula. Work it. A banking system holds 60 million dollars of deposits against a 20 percent requirement, which means 12 million dollars of required reserves and a multiplier of 5. Cut the requirement to 10 percent and two things happen at once: required reserves fall to 6 million dollars, freeing 6 million for lending, and the multiplier doubles to 10, so those freed reserves can support up to 60 million dollars of new deposits. Now rewind to the 20 percent requirement and cut the discount rate from 4 percent to 3 percent instead. The multiplier is still 5, because the required ratio never moved, and not one dollar of required reserves was released. What changes is how thin banks are willing to run, since topping up at the window just got cheaper, so they hold fewer excess reserves and lend more of what they already have. Both moves are expansionary. Only one of them touches the arithmetic, which is why a reserve requirement question can be finished with a calculator and a discount rate question cannot.
One is a price a bank can decline to pay, the other is a rule it cannot
The discount rate matters only to a bank that chooses to borrow from the Fed, and that borrowing is voluntary and usually short-term. A bank sitting comfortably above its reserve position can ignore a discount rate change entirely. That is why the tool is described as a backstop: the rate is normally set above the market rate for overnight reserves, so the window is where a bank goes when other funding is unavailable or expensive. The reserve requirement binds every depository institution in every period, with penalties for falling short, and no bank can opt out. The consequence for exam reasoning is the strength of the link. A reserve requirement change mechanically alters how much lending the system is permitted to do. A discount rate change alters incentives, and the effect on lending then depends on whether banks want to lend and whether borrowers want to borrow. Announced policy and realized money supply can diverge much further with the price tool than with the quantity rule.
The two tools show up in two different question formats
Reserve requirement questions are usually arithmetic. A prompt gives a required ratio and an amount of excess reserves, then asks for the maximum change in loans or in demand deposits, which is excess reserves multiplied by 1 divided by the ratio. Answer keys expect the word maximum, because the full expansion assumes no cash leakage and no excess reserves held back. Discount rate questions are usually chains of reasoning. A prompt announces that the Fed lowers the discount rate, then asks for the effect on the money supply, the nominal interest rate, investment, aggregate demand, and real output, in that order. Knowing which format is coming tells you what to write. A percentage stated as a fraction of deposits means computation. A policy announcement means a directional chain. The answer space is itself a hint: a reserve requirement prompt usually leaves you a blank line for a number or a T-account, while a discount rate prompt usually leaves you a labeled money market graph to draw on.
Frequently asked questions
Does lowering the discount rate change the money multiplier?
Lowering the discount rate leaves the money multiplier at 1 divided by the required reserve ratio, unchanged. The discount rate affects how many reserves banks are willing to borrow and how thin they are willing to run, not the fraction of deposits they are required to hold. Only a change in the reserve requirement changes the multiplier. On a free response, writing that a discount rate cut raises the multiplier makes the money supply calculation that follows wrong even when the direction of the effect is right.
Which of these two tools does the Fed rely on most?
Open market operations, a third tool outside this comparison, do the day-to-day work. Between the two here, the discount rate is adjusted regularly alongside other policy rate decisions, while the reserve requirement is rarely touched, because changing it hits every bank's balance sheet at once and is hard to fine tune. Exam questions still lean on the reserve requirement heavily, since it is the cleanest way to test whether a student can use the money multiplier.
If the reserve requirement is 25 percent and a bank has 40 million dollars in excess reserves, how far can deposits expand?
The banking system can create at most 160 million dollars of new deposits, since a 25 percent requirement makes the multiplier 1 divided by 0.25, which is 4, and 40 million times 4 is 160 million. Two traps hide inside that number. First, the bank holding the excess reserves can lend only 40 million itself, and the other 120 million appears as later banks re-lend the deposits those loans create, so writing 160 million for the single bank is wrong. Second, check whether the prompt gave you excess reserves or total reserves, because multiplying total reserves by 4 counts required reserves that can never be lent.
Live Money Market graph. Drag the curves, or open the full version.
Related comparisons
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