Course work in macroeconomics

1.1.1 Change in discount rate (discount policy)

         The discount rate is the provision of loans to commercial banks. In many states, the discount rate is the basis for a discretionary policy, a policy in which the government consciously manipulates government spending and taxes. It is also called active fiscal policy. It can be carried out using both direct and indirect tools.

         The central bank uses this method to control the volume of the monetary base. By changing this rate, the central bank can affect the reserves of banks, expanding or reducing their ability to provide loans to borrowers.

         If he wants to increase the money supply in the country, he lowers the discount rate. The demand of commercial banks for central loans is increasing, as they become more attractive than loans in the interbank market. By providing funds to commercial banks, the central one increases the reserves of borrowing banks by an appropriate amount, expanding the monetary base. These reserves are excessive and banks can use them to issue loans, thereby creating new money. Consequently, lowering the discount rate leads to an increase in money supply and expansion of lending to the economy.

         When the discount rate is increased to such a level that it becomes higher than the interbank market rate, commercial banks reduce borrowing from the central bank. This slows down the growth rate (or reduces) the money supply. The increase in the discount rate, respectively, leads to an increase in the interest rate on the interbank market and “increases the cost” of the loan provided to economic entities.

         A change in the discount rate cannot be considered an effective tool of monetary policy for a number of reasons: - Firstly, the central bank is not able to force commercial loans from it and therefore cannot accurately calculate what kind of change in the discount rate will lead to the desired increase or decrease money offers.

- Secondly, the discount rate is less mobile than the rate of the interbank market, since it takes time to make a decision on its change.

- Thirdly, the amount of funds borrowed from the central bank in the total reserves of commercial banks is insignificant. Therefore, its change cannot have a significant impact on the behavior of banks.