Federal Reserve Banks lend funds to depository institutions at the discount window. The discount rate is the interest rate charged to banks when they borrow from the Fed. If an eligible institutions needs to borrow money from the central bank they get access to these funds from their regional Federal Reserve Bank’s disount window. These loans are usually intended to be used on a short-term basis, typically overnight.

Discount window lending takes place through the reserve accounts depository institutions are required to maintain at their Federal Reserve Banks. In other words, banks borrow additional reserves at the discount window. All depository institutions that maintain transaction accounts or non-personal time deposits that are subject to reserve requirements are entitled to borrow at the discount window. These include commercial banks, thrift institutions, and United States branches and agencies of foreign banks. Eligible institution does not have to drain other sources of funds to meet reserve needs before coming to the discount window. Technically, there are no restrictions on the purposes for which the borrowing institution can use primary credit borrowed at the discount window.

The Federal Reserve can also influence reserves and money market rates through its administration of the discount window and the discount rate. Under certain Federal Reserve operating procedures, changes in the discount rate have a strong direct effect on the funds rate and other money market rates. A bank’s decision to borrow at the discount window depends on the relation of the discount rate to the federal funds rate, as well as on the administrative arrangements surrounding the use of the window. The Boards of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board. Adjusting the discount rate will often alter the amount of credit extended through discount window borrowing.

Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives. At the same time, the relative ease of borrowing at the discount window for reserves at the determined discount window rate effectively places a ceiling on the funds rate.

If the discount rate is increased, banks will tend to borrow less from the Fed and in turn have fewer reserves to make available increase lending to their customers. If the rate is decreased, banks will tend to borrow more from the Fed which increases the available funs they have for customer credit rewuests and since the rate they are borrowing from the Fed is lower, the rates they offer their customers are lower.

An increase in the discount rate can inhibit lending and investment activity of financial institutions by making it more expensive for institutions to obtain funds or reserves. But, if funds are readily available from sources other than the Fed’s discount window, a discount rate change won’t directly affect the flow of money and credit. Even so, a change in the discount rate can be an important signal of the Fed’s policy direction.

The most flexible, and therefore most important, of the monetary policy tools is open market operations.

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