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Discount Rate

Discount Rate

Author: Kate Eskra

Identify how the discount rate is used to manage the money supply.

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on the discount rate. As always, my key terms are in red and my examples are in green.

So this tutorial will talk about the tools the Fed has to manage our nation's money supply. You'll understand what the discount rate is and when and why banks need to pay it. And we'll talk about what the Fed will do to the discount rate when they either want to expand or contract the economy.

So the FOMC is our Federal Open Market Committee. And it's the part of the Fed that meets several times a year to manage our nation's money supply. They have various tools to control our money supply. And they are the reserve requirement, which is how much money banks have to keep on hand versus lending out; open market operations, or the buying and selling of US Treasury securities; the Fed funds market; and the discount rate. So today's tutorial is on the discount rate.

So we know that we have a fractional reserve system. And it all deals with how banks make money. If they just stored our money and did nothing with it, they wouldn't make any money. They wouldn't profit.

But when we deposit money into a checking account, we are certainly entitled to demand that at any time. I can write a check on it. I can swipe my debit card. For that reason, sometimes checking accounts are called demand deposits.

But banks make money by lending out at least a portion of our deposits to other people and then charging them interest. That's how they make their revenue. And it turns out that this system allows actually for the creation of money in our economy. And it works out well most of the time.

The problem only becomes if banks started lending out way too much money, or if for some reason many people show up one day demanding a lot of cash. If that's the fact, they can't meet their demands that day. This used to happen a lot. And banks would fail or go bankrupt. And so bank runs and panics were really common anytime people started losing confidence that banks would have enough money to meet their demands.

So because of how bad this is, these bank runs and panics can be on our macro-economy when people lose confidence and just run demanding all of their money, that's really terrible not just for our banking system, but for our overall economy, the Fed has stepped in. And they now regulate how much of these reserves banks have to hold in their vaults, or at the regional Fed bank. And what they do is they set a reserve requirement. It's a certain percentage, so let's say 10%.

If a bank can't meet their reserve requirement for the day for some reason, they're actually not permitted to close until it's been met. So sometimes they're in a situation where they just need to borrow money overnight. And they have two options.

Option one is they borrow from one another, they borrow from another Fed member bank that has some excess reserves to lend them. That's a subject of another tutorial. If that's the case, they would pay the Fed funds rate.

But in this tutorial, let's talk about the second option, which is when they actually borrow money from the Fed itself. When they borrow money from the Fed itself, they would pay the discount or window rate. This is the rate that the Fed charges member banks for short-term loans to meet temporary liquidity needs.

So the idea here is the greater the supply of funds that banks can loan out, the greater the ability to increase our money supply, because if banks can loan out money, that can get money out there circulating, getting into our hands. And that way we can go out and buy things and get out loans and build a house and buy a car, et cetera. So that's how our money supply can increase.

So if the Fed wants to for some reason increase the amount of loanable funds and pick the economy up and get it moving, they can lower this discount rate. If instead, they wanted to contract the money supply and make banks hold on to more money, or not make them but encourage money to stay in the banks, they could raise the discount rate.

So the idea here with expansionary or easy money policy is that if we lower the discount rate, that means that banks can borrow from the Fed at lower rates. In turn, that's going to make it easier for them to loan us money. If they're getting money at lower rates, then that's just going to end up lowering the rates that we pay. And if we get lower rates, then we're encouraged take out more loans. When it's easier for us to get loans then, this has an expansionary effect on the economy.

On the other side of it, if they wanted to tighten things up, tight money policy needs to contract the money supply and to encourage money to stay in the banking system and not out in people's hands in circulation, that's when they go about and raise the discount rate. So if they raise the rate, that's going to mean that banks have to pay higher rates to borrow from the Fed. If they're paying higher rates, then in turn that's going to make us pay higher rates probably, because it's going to make it more difficult and more expensive for them to loan us money. So when it's harder or more expensive for us to get loans, this has a contractionary effect on the economy. As rates go up, we don't want to take money out of the banks as much, because A, it's earning more interest in the banks, and B, we don't want to pay higher rates to get out loans to buy a home or buy a car.

So in this tutorial, we talked about how the Fed has several tools that they can use to manage our nation's money supply, and that the discount rate is just one of these tools. And it involves the rate that banks pay to borrow from the Fed, not one another. And banks might need to borrow from the Fed as a last resort to meet their reserve requirement overnight or short-term. To expand the economy, the Fed can lower this discount rate. To contract the economy, the Fed can raise this discount rate.

Thanks so much for listening. Have a great day.

Terms to Know
Discount (Window) Rate

The rate the Fed charges member banks for short-term loans to meet temporary liquidity needs.