What is the Federal Discount Rate?
The federal discount rate is the interest rate at which a bank can borrow from the Federal Reserve.
How Does the Federal Discount Rate Work?
To understand the federal discount rate, it is important to understand that banks derive income from making loans. When lending generates profit for banks, they are motivated to lend as much of their deposits as possible. This would be a problem if a large number of depositors were to suddenly want to withdraw their money. To prevent the panic that would naturally occur in this situation, the Federal Reserve maintains a fractional reserve banking system, which requires banks to keep a certain percentage of their deposits in cash.
When a bank is unable to meet the reserve requirement, it can borrow those funds from another bank or directly from the Federal Reserve. If it borrows from another bank, it can get a federal funds loan; borrowing from the Federal Reserve involves borrowing from the Fed's 'discount window' at the discount rate. The loans are unsecured and are for very short periods (typically overnight).
So an increase in the discount rate discourages banks from borrowing to meet reserve requirements, causing them to build up reserves (and thus lend out less money). A reduction in the discount rate has the opposite effect: it encourages banks to borrow to meet reserve requirements, which makes more money available for lending.
Why Does the Federal Discount Rate Matter?
The Federal Reserve sets the discount rate, and by doing so it influences the federal funds rate, which is the rate at which banks borrow from each other. So if the discount rate is lower than the federal funds rate, banks will probably prefer to borrow from the Federal Reserve when they need loans. This puts downward pressure on the federal funds rate.
Conversely, if the discount rate is higher that the federal funds rate, banks will probably borrow from each other rather than from the Federal Reserve. This puts upward pressure on the federal funds rate. In either case, the Federal Reserve can trigger a change in the federal funds rate by changing the discount rate. This is why the discount rate and the federal funds rate are generally closely correlated.
Because the increase in the supply of funds available for lending puts downward pressure on interest rates, changes in the discount rate can have widespread economic effects. Manipulation of the federal funds rate is one of three primary methods the Federal Reserve uses to control the money supply (the other two involve changing reserve requirements and buying or selling U.S. Treasurys on the open market).