DISCOUNT RATE

The discount rate is the interest rate charged member banks for loans from Federal Reserve Banks (FRB). The Federal Reserve System (FRS), established in 1913, has 12 FRBs in 12 districts and 25 FRB branches. All national commercial banks are required to be members of the FRS. Just as individuals use the banking services of a local bank, member banks use the banking services of the FRB in their district. The Federal Open Market Committee (FOMC) determines the interest rate or discount rate member banks pay when borrowing money from the RRB. The FOMC meets ten times a year, and depending on the monetary needs of the country, it adjusts the discount rate up or down.

A decrease in the discount rate increases the money supply by making money less expensive. This allows member banks to borrow more money, which is then made available in their localities. Member banks pass on the savings within a few days or weeks by lowering rates on loans to businesses. Likewise, rates on home mortgages, consumer loans, and credit cards began to fall, stimulating borrowing and spending. Businesses began growing and more jobs become available. When spending exceeds business' ability to produce goods, the price of goods goes up thereby increasing the rate of inflation. The FOMC may then find it necessary to increase the discount rate. The increased discount rate decreases the money supply by making money more expensive. This, in turn, discourages borrowing and spending, and the economy slows down.

When the FRS first began operating, the discount rates constituted the FRS' primary, almost exclusive, means of monetary control. By the second half of the twentieth century, the FRS influenced the flow of money to promote economic stability in three ways. It could change the discount rate, conduct open market operations (the sale or purchase of government securities), and change reserve requirements (the percentage of deposits all commercial banks are required to set aside). The discount rate is used to signal overall changes in the Federal Reserve monetary policy.

The discount rate ranged between 1.5 percent and 8 percent from 1922 to 1978, and then climbed to an all time high at 14 percent in 1981. With the economy faltering, the RFS lowered the rate in an effort to stimulate business activity. The rate fell relatively steadily to 4 percent in 1994, remaining between 4 and 5 percent through 1998.

See also: Federal Reserve System, Inflation, Interest