Discount Rate
What is Discount Rate?
The discount rate is the interest rate the Federal Reserve charges commercial banks that borrow from it directly for the short term.
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.
Discount Rate: a worked example
A bank ends the day $5 million short of its reserve requirement and has two places to find the money overnight. The discount window charges 5 percent. Another bank with spare reserves will lend at 3 percent. Using a 360 day year, one night at the window costs $5 million × 0.05 ÷ 360 = $694.44. The same night borrowed from the other bank costs $5 million × 0.03 ÷ 360 = $416.67, a saving of $277.77. Because the discount rate sits above the interbank rate, banks approach each other first and the window stays a backstop. Now let the central bank cut the discount rate to 2.5 percent. The overnight cost falls to $5 million × 0.025 ÷ 360 = $347.22, below the interbank option, so the window becomes the cheaper source and borrowed reserves flow into the system.
The mistake students make with discount rate
A discount rate cut gets treated as if it mechanically expands the money supply the way an open market purchase does, so students invent a quantity of new reserves and run it through the money multiplier. Nothing has entered the banking system yet. A cut only lowers the price of borrowing reserves, and deposits grow only when banks actually choose to borrow at the window and lend those reserves out. Write the step as a change in incentive, then say what banks do in response, rather than reaching for a multiplier with no number to multiply.
Discount Rate questions
What is the difference between the discount rate and the federal funds rate?
The discount rate is charged by the central bank when banks borrow reserves directly from it. The federal funds rate is charged by one bank lending its own excess reserves to another bank overnight. One is administered, meaning the central bank simply announces it, while the other is a market price the bank steers by adding or draining reserves. The discount rate normally sits above the federal funds target so the window stays a last resort.
Why would a bank borrow from the central bank instead of another bank?
A bank turns to the discount window when it cannot cover a reserve shortfall in the interbank market, for example during a panic when other banks hoard their own reserves, or when the discount rate has been cut below the going overnight rate. Borrowing at the window is short term, usually overnight, and is backed by collateral, which is why the window works as a lender of last resort.
Does the discount rate set what banks charge their customers?
Customers borrow at rates their bank sets, well above the discount rate. The central bank charges the discount rate to banks borrowing reserves, and each bank then quotes a customer rate that covers default risk, a longer term, servicing costs, and profit. Cheaper reserves do pull consumer loan rates down over time, but the pass through is partial, and a car loan quote moves for reasons that have nothing to do with the window.
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