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PAYROLL TAX: A tax levied on the wage earnings, or payroll, of workers. The most notable, if nothing else in terms of sheer dollar amount, is the Social Security tax.

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DISCOUNT RATE:

The interest rate charged by the Federal Reserve System (the Fed) for loans to commercial banks, which in principle can be used as a means of a controlling the money supply. An increase in the money supply can be achieved when the Fed lowers the discount rate. A decrease in the money supply can be achieved when the Fed raises the discount rate. The discount rate, which is set by Federal Reserve Banks, subject to approval by the Board of Governors, is used more to signal changes in monetary policy rather than to actually control the money supply. The discount rate is one of the three monetary policy tools that the Fed can use, in principle, to control the money supply. The other two are open market operations and reserve requirements.
The discount rate is the interest rate that Federal Reserve Banks charge when commercial banks borrow reserves. In principle, a decrease in the discount rate encourages banks to borrow, which increases the amount of available reserves held by the banking system, which then induces an increase in the money supply and a decrease in interest rates. An increase in the discount rate works in the opposite direction, discouraging borrowing, reducing available reserves, decreasing the money supply, and increasing interest rates.

Although the Fed, in principle, can use the discount rate to control the total quantity of money in circulation, in practice, the discount rate is used primarily as a signal for monetary policy actions undertaken through open market operations.

In the early years of the Federal Reserve System, before the emergence of modern financial markets, the discount rate was the primary tool of monetary policy. At that time reserve lending subject to the discount rate was the most effective means available for the Fed to control the amount of bank reserves and thus the money supply.

In modern times, the discount rate is simply less effective in controlling the amount of reserves held by banks than open market operations. Banks borrow reserves from the Fed for reasons beyond the discount rate, meaning a higher or lower discount rate might have very little impact on reserves and the money supply.

Basic Process

The Federal Reserve System can use, in theory, the discount rate as a monetary policy tool for controlling the money supply and interest rates. The process would work like this:
  • First, after evaluating the state of the economy, the Fed determines whether the money supply needs to increase or decrease and by how much.

  • Second, if the Fed wants to increase the money supply it lowers the discount rate and if it wants to decrease the money supply it raises the discount rate. The actual rates are set by the Federal Reserve Banks subject to approval by the Board of Governors.

  • Third, the higher or lower rate motivates commercial banks to borrow fewer or more reserves from the Fed. If the discount rate is higher, then banks borrow fewer reserves. If the discount rate is lower, then banks borrow more reserves.

  • Fourth, the change in reserves induces banks to change its lending activity. With more reserves, banks are willing to make more loans. With fewer reserves, banks are willing to make fewer loans.

  • Fifth, the change in bank lending affects the creation of checkable deposits, which are an important component of the money supply. More loans mean more deposits and an increase in the money supply. Fewer loans mean fewer deposits and a decrease in the money supply.

  • Sixth, the change in bank lending also affects interest rates. If banks are willing to lend more, then interest rates fall. If banks are willing to lend less, then interest rates rise.

Lower or Higher, More or Less

The end result of a change in the discount rate is a change in the money supply and a change in interest rates. Should the Fed decide that the economy is in or heading toward a recession, then it is inclined to lower the discount rate and implement expansionary monetary policy. If the Fed thinks the economy is overly stimulated with higher inflation setting in, then it is likely to raise the discount rate and implement contractionary monetary policy.
  • Expansionary Monetary Policy: An increase the money supply and a reduction in interest rates results when the Fed lowers the discount rate. This is the recommended monetary policy to counter a recession, to stimulate the economy, and to reduce the unemployment rate.

  • Contractionary Monetary Policy: A decrease the money supply and a boost in interest rates results when the Fed raises the discount rate. This is the recommended monetary policy to counter an overheated expansion, to put the brakes no the economy, and to reduce the inflation rate.

Discount Lending

One of the most important functions of the Federal Reserve System is providing reserve loans to commercial banks. The Federal Reserve System was largely created for (and owes its name to) this particular function. Bank panics of the late 1800s and early 1900s were worsened by the inability of commercial banks to obtained reserves when economic conditions turned bad. The Fed was created in 1913 to provide the reserves banks needed to remain in business. The Fed was the lender of last resort, a safety net, for banks that were literally hours away from permanently closing their doors.

The interest rate that the Fed charged on loans to troubled banks became known as the "discount rate" and the lending is processed through the "discount window" maintained by each of the Federal Reserve Banks. This "discount" terminology arose from the original lending mechanism used by the Fed. To obtain reserves, banks would put up or pledge a portion of their non-reserve financial assets, such as U.S. Treasury securities or outstanding loans, as collateral. The Fed would then make a reserve loan slightly less than or discounted from the value of the collateral. The bank would then repay the full value of the collateral. The difference between the discounted value borrowed and the amount repaid, the discount rate, was effectively the interest rate paid on the loan.

Suppose, for example, that Shady Valley National Bank has experienced a bit of a bank run and finds itself a few million dollars short of the reserves needed to satisfy customer withdrawals and process checks on an otherwise tranquil Tuesday afternoon. To borrow the needed reserves, it sets aside $10,000,000 worth of outstanding home mortgage loans as collateral. The Fed then can then make a one day reserve loan of something like $9,998,630.14. Shady Valley National Bank then repays the full $10,000,000 the next day, once the emergency has past. The difference of $1,369.86 is the discount, which is 0.0137 percent of the total and works out to an annual interest (discount) rate of 5 percent.

Modern Discount Lending

Modern discount lending has evolved somewhat from the early years of the Fed. While modern banks continue to borrow for short-term emergencies, other types of reserve borrowing are also important. Moreover, banks no longer pledge other financial assets as collateral. The Fed simply extends a reserve loan and charges banks the discount interest rate.

For example, Shady Valley National Bank is more likely to borrow $10,000,000 of reserves, then repay $10,001,370.05 the next day, which is also an annual discount rate of 5 percent.

The three specific reasons commercial banks borrow reserves are:

  • Adjustment: These are short-term (usually overnight, but up to a couple of days) emergency loans that ensure banks have sufficient reserves to conduct day-to-day transactions. While some banks might need adjustment loans to avoid bank runs and stay in business, others use the loans to stabilize day-to-day fluctuations in reserves caused by an unusually high number of withdrawals on a given day.

  • Seasonal: These are loans made to smaller banks that are subject to seasonal fluctuations in deposits or withdrawals, often associated with a dominant industry in their community. Banks that include a large number of farmers as their customers are prime examples. These banks are likely to experience a seasonal drop in reserves during the planting seasons as farmers purchase supplies and inputs, then an increase in reserves during the harvest season as farmers sell their crops. Seasonal loans help banks make the transition.

  • Extended: These are longer-term (weeks or months) loans provided to banks with serious liquidity and financial problems. These banks often need an extended period to rearrange their asset portfolios, restructuring their loans, expand their deposit base, and otherwise get their business house in order.
The official, commonly reported discount rate is actually the "base" interest rate for loans to commercial banks. However, Federal Reserve Banks have the discretion to charge higher rates. For example, longer-term extended loans often carry an interest rate that exceeds the base rate. To discourage abuse of the system, Federal Reserve Banks are also inclined to charge higher rates to commercial banks that do an excessive amount of discount borrowing.

In the early years of the Fed, discount lending was limited to commercial banks that were members of the Federal Reserve System (national banks and state banks that joined the system). However, in the modern world all depository institutions that are subject to Federal Reserve regulations--tradition banks (national and state), savings and loan associations, credit unions, and mutual savings banks--can borrow reserves from the Fed.

Who's In Charge

Authority over the discount rate is divided between the Board of Governors and Federal Reserve Banks.
  • The Board of Governors is the policy making body of the Federal Reserve System. They set the regulations, rules, and policies affecting the money supply and the commercial banking system. The Board of Governors is comprised of 7 members who are appointed by the President and approved by the Senate. These 7 members also form the core of the 12-member Federal Open Market Committee that is charged with open market operations.

  • The Federal Reserve System contains 37 Federal Reserve Banks, including 12 District Banks and 25 Branch Banks. These banks are largely responsible for supervising, regulating, and interacting with commercial banks and carrying out the policies established by the Federal Reserve Board of Governors. The 12 District Banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.
Federal Reserve Banks set the discount rate subject to approval by the Board of Governors. While each Fed Bank, in theory, has control over the discount rate that it charges commercial banks, in practice, the actual rate is coordinated with other monetary policy actions (especially open market operations) through the Board of Governors and the Federal Open Market Committee.

In the early history of the Federal Reserve System, each Federal Reserve Bank did in fact set its own discount rate, which often differed across Federal Reserve Districts. The different rates were set to reflect different regional credit market conditions. Interest rates might be high in New York, but low in Dallas. The credit market might have a surplus of funds in San Francisco and a shortage in Atlanta.

However, as the credit market became more national, interest rate differentials larger disappeared and so too did the need to set different discount rates. But the authority to initiate changes the discount rates they charge remains with the Federal Reserve Banks.

How It All Works

Once the policy makers of the Federal Reserve System (Board of Governors, Federal Open Market Committee, Federal Reserve Bank presidents) decided that a change in the discount rate is in order, the Federal Reserve Banks submit the change to the Board of Governors for official approval. One of the 12 Federal Reserve District Banks might actually take the lead in implementing this change, quickly followed by the other 11 District Banks.

A lower discount rate is designed to encourage reserve borrowing by commercial banks and a higher rate is intended to discourage borrowing. Because most commercial banks do not take advantage of reserve borrowing from the Fed, changes in the discount rate have only a modest impact on total commercial bank reserves. Commercial banks are usually more concerned about other factors, such as their need for reserves to remain in business, than the discount rate when they borrow from the Fed. This is why the discount rate is primarily used as a signal for other monetary policy actions.

To the extent that reserves do change, a lower discount rate causes an increase in reserves and a higher discount rate causes a decrease in reserves. As reserves change, commercial banks are more or less willing to make loans, both to their customers as well as to other commercial banks.

A lower discount rate that motivates an increase in lending results an increase in checkable deposits, an increase in the money supply, and a decrease in interest rates. A higher discount rate that motivates a decrease in lending results a decrease in checkable deposits, a decrease in the money supply, and an increase in interest rates.

Accommodating Rate Changes

The most newsworthy and noteworthy changes in the discount rate are those designed to signal an expansion or contraction the money supply through open market operations, in response to recessionary or inflationary business cycle conditions. However, the discount rate is also changed from time to time to keep it in line with other interest rates.

The discount rate that the Fed charges commercial banks for reserve lending is inevitably less that the Federal funds rate, the interest rate commercial banks charge each other for reserve lending. Even though reserve lending by the Fed is intended for troubled banks, more than a few healthy banks borrow reserves from the Fed at the lower discount rate, then loan those reserves to other banks at the higher Federal funds rate.

This can be an extremely profitable activity, even though the difference between the discount rate and Federal funds rate is usually not much, because millions of dollars of reserves are involved. However, should the difference in the rates increase, then commercial banks are more inclined to pursue this profitable activity--something the Fed does not particularly like.

As such, the Fed is likely to adjust the discount rate to limit the size of this gap and keep the discount rate in line with the Federal funds rate. This adjustment is not intended to signal any particular monetary policy.

Two Other Tools

The discount rate is one of three tools that the Fed can use, in theory, to control the money supply. The other two are the open market operations and reserve requirements.
  • Open Market Operations: The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.

  • Reserve Requirements: The Fed can further adjust the proportion of reserves that banks must keep to back outstanding deposits (the reserve ratio). Higher and lower rates affect the deposit multiplier and the amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve requirements, then banks can use existing reserves to make more loans and thus increase the money supply. If the Fed raises reserve requirements, then banks can use existing reserves to fewer more loans and thus decrease the money supply. This tool is seldom used as a means of controlling the money supply.

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Recommended Citation:

DISCOUNT RATE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: April 20, 2014].


Check Out These Related Terms...

     | monetary economics | monetary policy | open market operations | reserve requirements | central bank | expansionary monetary policy | contractionary monetary policy | Federal Reserve pyramid | Board of Governors, Federal Reserve System | Chairman of the Board of Governors, Federal Reserve System | Federal Reserve Banks | Federal Open Market Committee | Federal Advisory Council |


Or For A Little Background...

     | fractional-reserve banking | banks | money | bank reserves | bank panic | business cycles | check clearing | money creation | macroeconomics | monetary base | monetary aggregates | unemployment | inflation |


And For Further Study...

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     | Federal Reserve System |


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