Discount rate

The interest rate that banks pay on loans made to them from the Federal Reserve. Banks whose reserves dip below the reserve requirement set by the Federal Reserve's Board of Governors must take immediate action to make good their shortfall. The Federal Reserve is normally willing to make a short-term loan of reserves to a bank in this situation to give the bank a brief period of time to make adjustments in its loan and investment portfolio that will permit it to raise its reserves or lower its loans outstanding. (The bank might stop making new loans for a few days while the normal repayment flow on old loans proceeds to top up their cash position. If the situation is truly critical, the bank might even begin calling in some of its loans that it would normally have been willing to renew.) Bankers normally do not like to borrow money from the Fed in this manner, partly because the interest they must pay to the Fed for such a loan (the discount rate) is normally higher than other short-term borrowing rates, but mostly because this may trigger closer regulatory scrutiny by the Fed. If possible, they prefer to borrow reserves from other banks that have excess reserves at the Fed. The Fed uses changes in the discount rate as another tool of monetary policy. Raising the discount rate makes it more expensive to borrow from the Fed, and bankers tend to build up their reserve position further above the minimum percentage legally required, just to be extra sure they will not be put to this unnecessary trouble in case their projection of the flow of loan repayments by their customers turns out to be a little on the high side. The more conservative reserve position diminishes the volume of the loans they would otherwise be making, and so an increase in the discount rate tends to cause a decrease in the money stock and thus higher short-term interest rates.

In contrast, lowering the discount rate is expansionary. As the cost of borrowing from the Fed to meet a temporary emergency falls, bankers tend to reduce their excess reserves to a minimum, extending more loans and thus increasing the money stock and tending to lower interest rates in the short term.

[See also: Federal Reserve System, interest rate(s), monetary policy, money stock, reserve requirement]