Introduction to Finance

Fed discount rate
 
is the interest rate that a bank or other 
depository institution must pay to borrow from its regional Federal Reserve Bank. The Federal 
Reserve Banks currently off er three discount window programs referred to as primary credit, 
secondary credit, and seasonal credit. The 
primary credit rate
is the Fed’s main discount win-
dow program and, in practice, its rate is used interchangeably with the term “discount rate.” While 
each Fed Bank sets its own discount rate, the rates have been similar across all 12 Reserve Banks 
in recent years. The Fed sets the interest rate on these loans to banks and, thus, can infl uence the 
money supply by raising or lowering the cost of borrowing from the Fed. Higher interest rates 
will discourage banks from borrowing, while lower rates will encourage borrowing. Increased 
borrowing will allow banks to expand their assets and deposit holdings, and vice versa.
Loans to depository institutions by the Reserve Banks may take two forms. One option 
allows the borrowing institution to receive an advance, or loan, secured by its own promissory 
note together with “eligible paper” it owns. In the second option, the borrower may discount—
or sell to the Reserve Bank—its eligible paper, which includes securities of the U.S. govern-
ment and federal agencies, promissory notes, mortgages of acceptable quality, and bankers’ 
acceptances. This discounting process underlies the use of the terms “discount window” and 
“discount rate policy.”
Discount rate policy was originally intended to work in the following fashion. If the 
Fed wanted to cool an infl ationary boom, it would raise the discount rate. An increase in 
the discount rate would lead to a general increase in interest rates for loans, decreasing the 
demand for short-term borrowing for additions to inventory and accounts receivable. This, in 
turn, would lead to postponing the building of new production facilities and, therefore, to a 
decreased demand for capital goods. As a consequence, the rate of increase in income would 
slow down. In time, income would decrease and with it the demand for consumer goods. 
Holders of inventories fi nanced by borrowed funds would liquidate their stocks in an already 
weak market. The resulting drop in prices would tend to stimulate the demand for, and reduce 
the supply of, goods. Thus economic balance would be restored. A reduction in the discount 
rate was expected to have the opposite eff ect.
Discount policy is no longer a major instrument of monetary policy and, in fact, is now 
regarded more as an adjustment or fi ne-tuning mechanism. As an adjustment mechanism, the 
discount arrangement does provide some protection to depository institutions in that other 
aggressive control actions may be temporarily moderated by the ability of banks to borrow. 
For example, the Fed may take a strong restrictive position through open-market operations. 
Individual banks may counter the pressure by borrowing from their Reserve Banks. The 
Reserve Banks are willing to tolerate what appears to be an avoidance of their eff orts while 
banks are adjusting to the pressure being exerted. Failure to reduce their level of borrowing 
can always be countered by additional Fed open-market actions.