A:

A low federal discount rate is used as an expansionary tool of monetary policy by the Federal Reserve. Theoretically, setting a low discount rate should encourage banks to extend more loans and encourage consumers to spend more money. According to Keynesian demand-side macroeconomic policy, increased lending and spending in the economy shift the aggregate demand curve to the right and improve an ailing economy. The intended benefit of a rightward shift in aggregate demand is to increase the quantity of output and create business expansion.

The discount rate is not a direct tool. It represents the interest rate that the Fed charges to commercial banks to borrow money, making it relatively less attractive for bankers to hold excess reserves. Those excess reserves might then be loaned out to businesses, investors and individual consumers, supposedly stimulating economic activity. Due to its influence in financial markets and the market for loanable funds, the discount rate is considered to be a leading economic indicator.

There is another, less publicized benefit to lowering the discount rate: It helps existing debtors at the expense of existing creditors. As the demand for loans increases, the market rate of interest tends to drop and borrowing costs decline. This is especially true for the federal government, which tends to roll over the national debt into cheaper rates and save on interest payments.

In the United States, there are several different rates charged through the discount window: the primary credit rate, the secondary credit rate and the seasonal credit rate. The primary credit rate is the most commonly used and is believed to be the most influential on a macro level.

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