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What is the 'Federal Discount Rate'

The federal discount rate is the interest rate set by the Federal Reserve on loans offered to eligible commercial banks or other depository institutions as a measure to reduce liquidity problems and the pressures of reserve requirements. The discount rate allows the federal reserve to control the supply of money and is used to assure stability in the financial markets.

BREAKING DOWN 'Federal Discount Rate'

Depository institutions and commercials banks that are in generally sound financial condition are eligible to borrow from their regional Federal Reserve banks at a primary credit, or discount, rate. These loans are normally extended on an overnight basis for the purpose of banks meeting short-term liquidity needs. Funds for commercial banks borrowed from the Fed to improve their money supply are processed through the discount window, and the rate is reviewed every 14 days. The federal discount rate is one of the most important indicators in the economy, as all other interest rates move up and down with it.

Federal Reserve Monetary Tools

The federal discount rate is used as a tool to either stimulate (expansionary monetary policy) or rein in (contractionary monetary policy) the economy. A decrease in the discount rate makes it cheaper for commercial banks to borrow money, which results in an increase in available credit and lending activity throughout the economy. Conversely, a raised discount rate makes it more expensive for banks to borrow and thereby diminishes the money supply while retracting investment activity.

Besides setting the discount rate, the Federal Reserve can influence money supply, credit and interest rates through open market operations in U.S. Treasury markets, and by raising or lowering reserve requirements for private banks. The reserve requirement is the portion of a bank's deposits that it must hold in cash form, either within its own vaults or on deposit at its regional Reserve bank. The higher reserve requirements are, the less room banks have to leverage their liabilities, or deposits. Higher reserve requirements are more typical during a recession when a central bank wants to ensure banking panics and runs don't cause financial failures. The Federal Reserve acts upon its dual mandate to maximize employment and reduce inflation.

The discount rate is determined by the Federal Reserve's Board of Governors, as opposed to the federal funds rate which is set by the Federal Open Markets Committee (FOMC). The FOMC achieves the fed funds rate through the open sale and purchase of U.S. Treasuries, whereas the discount rate is reached solely through review by the Board of Governors.

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