How Does a High Discount Rate Affect the Economy?

Setting a high discount rate tends to have the effect of raising other interest rates in the economy since it represents the cost of borrowing money for most major commercial banks and other depository institutions. This could be considered a contractionary monetary policy. Exactly how much a high discount rate affects the economy as a whole depends on the relationship between the discount rate and the normal market rate of interest for loans to banks.

In part, interest rates represent the cost of borrowing money. When it is less expensive for banks to borrow money from the Federal Reserve, they can subsequently charge less interest on their own loans. This has a ripple effect on the demand for loanable funds everywhere unless the market rate of interest is equally as high.

Interest rates also coordinate savings in the economy. When too few actors want to save money, banks entice them with higher interest rates. Between savings and loans, interest rates help coordinate economic activity between different actors and different points in time. Savings represent a preference for future consumption over present consumption, while the opposite is true for borrowing. If the discount rate is raised too high, it could throw this coordinating mechanism out of balance.

More immediate impacts are felt from a high discount rate. Loans are more expensive, and borrowers have to work to pay off loans more quickly. This has the effect of taking money out of the economy, which could also cause prices to decline. Individuals are encouraged to save more. This leads to an increase in capital funding. Whether this helps or harms the economy depends on many other factors and is very difficult to gauge.

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