When discount rates are high, it is more costly for commercial banks and financial institutions to borrow short-term loans from the Federal Reserve. In turn, this makes it harder for banks to lend money out, making it more expensive for consumers to borrow and invest. As an economic tool, the Federal Reserve can use a high discount rate to encourage saving over spending and to cool inflation.
Key Takeaways
- A high discount rate mean that it is more costly for banks and other financial institutions to borrow money from the Federal Reserve.
- When discount rates are high, banks may lend less to consumers.
- As a monetary tool, the Federal Reserve may raise discount rates to encourage people to borrow less and save more.
- In the short term, high discount rates make loans more expensive, which takes money out of 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.
How Are High Discount Rates Used as an Economic Tool?
In general, high discount rates can increase other interest rates, as well, which are used to coordinate savings across the economy. When too few actors want to save money, higher interest rates can entice them to save more.
Between savings and loans, interest ratesalso help coordinate economic activity across different actors and different points in time. Savings represent a preference for future consumption over present consumption, while the opposite is true for borrowing.
Interest rates are one way that the Federal Reserve can control inflation. When inflation is too rapid, raising discount rates—which in turn nudges other interest rates up—is one way to bring spending down.
A high discount rate can have more immediate impacts, as well. When loans become more expensive, borrowers may have to work to pay them off more quickly. This has the effect of taking money out of the economy, which could also cause prices to decline. Individuals might also feel encouraged to save more, which can lead to an increase in capital funding. Whether this helps or harms the economy depends on many other factors and is very difficult to gauge.
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.
What Happens If the Discount Rate Is Too High?
High discount rates are a measure that the Federal Reserve can use to cool the economy during period of rapid inflation. However, a high discount rate can also contribute to a slowing down of economic activity.
Does Lowering the Discount Rate Stimulate the Economy?
Lowing the discount rate makes it cheaper for banks to borrow money. As a ripple effect, they may issue loans to consumers at lower rates, as well. This effectively makes it easier to borrow, which can stimulate growth and increase inflation.
Are the Federal Funds Rate and the Discount Rate the Same?
Both the federal funds rate and the discount rate are monetary tools of the Federal Reserve. The funds rate is the interest rate on loans between banks, whereas the discount rate is the interest rate for funds borrowed directly from the Federal Reserve.
The Bottom Line
High discount rates mean that it's more costly for commercial banks and other financial institutions to borrow money from the Federal Reserve. This can have ripple effects across the economy. High discount rates can increase other interest rates, making it more expensive to borrow money. During periods of rapid inflation, the Federal Reserve may increase discount rates to encourage saving over spending.
