Federal Reserve and Money Supply II

The discount rate, officially called the primary credit rate, is the interest rate the Federal Reserve charges when lending directly to commercial banks through the “discount window.”

This tool is part of the Fed’s role as lender of last resort. Consider Bank A. In exceptional situations, when it can’t borrow from Bank B or Bank C—typically at the federal funds rate, the rate banks charge each other—it may turn to the Fed instead.

If the Fed sets a low discount rate, it becomes cheaper for banks to borrow from the Fed. This supports continued lending to businesses and consumers, helping to sustain the money supply during periods of stress.

If the Fed raises the rate, borrowing becomes more expensive. Banks often avoid the discount window—not just due to cost, but also the stigma that borrowing signals financial trouble. Lending may slow, reducing the flow of money.

In modern policy, the discount rate plays a limited yet important role. It acts as a ceiling for short-term interest rates, helping the Fed keep the federal funds rate within its target range.