Discount Rate vs Reserve Requirement
Discount Rate and Reserve Requirement are two Money & Monetary Policy concepts in AP Economics that students often mix up. In short: discount rate is the interest rate the Federal Reserve charges commercial banks for short-term loans. Meanwhile, 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.
The interest rate the Federal Reserve charges commercial banks for short-term loans.
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 percentage of deposits that banks are legally required to hold as reserves rather than lend out.
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.
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