The Discount Rate

The third tool in the Fed’s toolbox is the discount rate, the interest rate on the
loans that the Fed makes to banks. A bank borrows from the Fed when it has too few reserves to meet its reserve requirements. This might occur because the bank made too many loans or because it has experienced unexpectedly high withdrawals. When the Fed makes such a loan to a bank, the banking system has more reserves than it otherwise would, and these additional reserves allow the banking system to create more money. The Fed can alter the money supply by changing the discount rate. A higher discount rate discourages banks from borrowing reserves from the Fed. Thus, an increase in the discount rate reduces the quantity of reserves in the banking system, which in turn reduces the money supply. Conversely, a lower discount rate encourages banks to borrow from the Fed, increases the quantity of reserves, and increases the money supply.