Definition
The term discount rate refers to the rate of interest charged commercial banks when they borrow funds at the discount window. There are three discount window programs offered to depository institutions.
Explanation
The discount rate is one of the three tools used by the Federal Reserve to achieve its monetary policy goals. As is the case with the reserve requirements, and open market operations (OMO), the discount rate can be used to control the money supply. The discount rate is the rate of interest charged for short-term loans made by the twelve Reserve Banks to commercial banks. It is also one of the tools the Federal Reserve can use to control the money supply.
Lowering the discount rate will encourage additional lending by commercial banks and supports an expansionary monetary policy, while increasing the discount rate makes it more expensive to borrow money and supports a contractionary policy. The Board of Governors sets the discount rate. There are three different discount lending programs:
Primary Credit: the rate of interest is typically higher than other short-term interest rates like the fed funds rate. Commercial banks borrowing at primary credit are generally in good financial condition.
Secondary Credit: banks that do not qualify for primary credit can apply for a secondary credit loan. These banks are typically having financial difficulties and need short-term liquidity. The rate of interest on these loans is higher than that charged for primary credit loans.
Seasonal Credit: banks serving seasonal customers, such as those in agricultural communities, can apply for a seasonal credit loan. These loans are typically limited to small depository institutions that have a recurring intra-year funding need. The rate of interest charge for seasonal credit is an average of selected market rates.
Each of these programs has a unique rate of interest charged on loans. Unlike fed funds, loans made through the discount window are consider secured loans.
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