DISCOUNT RATE

The term "discount rate" has different meanings depending on the context in which it is used. In one sense the discount rate may simply refer to the interest rate used in present value calculations. That is, the discount rate is the interest rate used to calculate the present value of money to be received in the future. In the context of economic and monetary policies, especially regarding banks and bank lending, the discount rate is the interest rate that Federal Reserve banks charge on loans to member banks. The Federal Reserve discount rate is the same throughout the Federal Reserve System. In the days before regional credit markets became a single national market, each of the 12 Federal Reserve banks could set its own discount rate to reflect regional banking and credit conditions.

The discount rate is one of the tools used by the Federal Reserve System to control bank lending and expansion. By raising or lowering the discount rate the Federal Reserve System can encourage or discourage member banks from borrowing from the Federal Reserve's discount window. If the discount rate is low in comparison to other interest rates, banks will be stimulated to borrow at the discount window. On the other hand, if the discount rate is high in comparison to other interest rates, banks will consider other sources of funds. Through such borrowing banks can increase their reserves and raise the overall expansion power of the banking system.

Over the years the Federal Reserve's control over the discount rate has proved to be an ineffective tool for controlling bank lending and expansion. The primary reason for this is that most banks are reluctant to go into debt with the Federal Reserve, even for a short time. In practice, then, lowering the discount rate has not effectively stimulated bank borrowing from the Federal Reserve's discount window. Banks continue to borrow from the Federal Reserve, but usually only when they unexpectedly have insufficient reserves to meet their legal requirements. The Federal Reserve views the use of the discount window as complementary to its more effective open-market operations, by which the Federal Reserve controls member bank reserves through the purchase and sale of U.S. government securities on the open market.

The Federal Reserve reviews the discount rate and adjusts it periodically to bring it in line with other money market rates. Changes in the discount rate may serve as a signal from the Federal Reserve of its future monetary policies. Changes in the discount rate can also affect other money market rates as well as investment strategies in stocks, bonds, and other securities.