A:

The central bank for the United States – the Federal Reserve (the Fed) – is tasked with maintaining a certain level of stability within the country's financial system. Specific tools are afforded the Fed that allow for changes to broad monetary policies intended to implement the government's planned fiscal policy. These include the management and oversight of the production and distribution of the nation's currency, sharing of information and statistics with the public, and the promotion of economic and employment growth through the implementation of changes to the discount rate.

The most influential economics tool the central bank has under its control is the ability to increase or decrease the discount rate. Shifts in this crucial interest rate have a drastic effect on the building blocks of macroeconomics, such as consumer spending and borrowing.

What Is the Discount Rate?

For banks and depositories, the discount rate is the interest rate assessed on short-term loans acquired from regional central banks. Financing received through federal lending is most commonly used to shore up short-term liquidity needs for the borrowing financial institution; as such, loans are extended only for an overnight term. The discount rate can be interpreted as the cost of borrowing from the Fed.

Decrease to the Discount Rate

When the Fed makes a change to the discount rate, economic activity either increases or decreases depending on the intended outcome of the change. When the nation's economy is stagnant or slow, the Federal Reserve may enact its power to reduce the discount rate in an effort to make borrowing more affordable for member banks. (For related reading, see: How does the Federal Reserve determine the discount rate?)

When banks can borrow funds from the Fed at a less expensive rate, they are able to pass the savings to banking customers through lower interest rates charged on personal, auto or mortgage loans. This creates an economic environment that encourages consumer borrowing and ultimately leads to an increase in consumer spending while rates are low.

Although a reduction in the discount rate positively affects interest rates for consumers wishing to borrow from banks, consumers experience a reduction to interest rates on savings vehicles as well. This may discourage long-term savings in safe investment options such as certificates of deposit (CDs) or money market savings accounts.

Increase to the Discount Rate

When the economy is growing at a rate that may lead to hyperinflation, the Fed may increase the discount rate. When member banks cannot borrow from the central bank at an interest rate that is cost-effective, lending to the consuming public may be tightened until interest rates are reduced again. An increase to the discount rate has a direct impact on the interest rate charged to consumers for lending products, and consumer spending shrinks when this tactic is implemented. Although lending is not as attractive to banks or consumers when the discount rate is increased, consumers are more likely to receive more attractive interest rates on low-risk savings vehicles when this strategy is set in motion. (For related reading, see: How does a high discount rate affect the economy?)

 

RELATED FAQS
  1. How does monetary policy influence inflation?

    Take a deeper look at how contemporary central banks attempt to target and control the level of inflation through monetary ... Read Answer >>
  2. How is terminal value discounted?

    Find out why investors use the terminal value, why the terminal value is discounted to the present day, and how it relates ... Read Answer >>
  3. Why do interest rates change?

    Interest rates affect many facets of borrowing money and is based off of supply and demand. Interest rates also vary based ... Read Answer >>
Related Articles
  1. Personal Finance

    How the Federal Reserve Affects Your Mortgage

    The Federal Reserve can impact the cost of funds for banks and consequently for mortgage borrowers when maintaining economic stability.
  2. Insights

    The Impact of a Fed Interest Rate Hike

    The Federal Reserve raised benchmark interest rates. With so much attention on the Fed's policy, here's what happens when the Fed hikes rates.
  3. Personal Finance

    How interest rate cuts affect consumers

    Traders rejoice when the Fed drops the rate, but is it good news for all? Find out here.
  4. Trading

    Why Interest Rates Affect Everyone

    Learn why interest rates are one of the most important economic variables and how every individual and business is affected by rate changes.
  5. Investing

    How Interest Rates Affect Mutual Funds

    Find out how changing interest rates impact mutual funds, including bond and money market funds, and how higher rates can discourage investors.
  6. Personal Finance

    How Interest Rates Can Go Negative

    Central banks from Europe to Japan have implemented a negative interest rate policy (NIRP) in order to stimulate economic growth.
  7. Financial Advisor

    Implications of the Federal Reserve's Impending Rate Hike

    The Federal Reserve begins its two-day meeting on Wednesday, September 16, and everyone is watching to see if the central bank will raise the United States target interest rate for the first ...
  8. Insights

    How Central Banks Control the Supply of Money

    A look at the ways central banks pump or drain money from the economy to keep it healthy.
  9. Insights

    Central Bank

    They print money, they control inflation, they are known as the "lender of last resort". Check out the role of Central Bank nd how its role evolved overtime.
RELATED TERMS
  1. Discount Rate

    Discount rate is the interest rate charged to commercial banks ...
  2. Discount Points

    Discount points are a type of prepaid interest mortgage borrowers ...
  3. Bank Discount Rate

    The bank discount rate is the interest rate for short-term money-market ...
  4. Discount Window

    Discount window is a central bank lending facility meant to help ...
  5. Discounting

    Discounting is the process of determining the present value of ...
  6. Discount Note

    A discount note is a short-term debt obligation issued at a discount ...
Trading Center