Discount Rate Law and Legal Definition

Discount rate refers to the interest rate that banks pay on loans to them from the Federal Reserve. Banks whose reserves dip below the reserve requirement set by the Federal Reserve's Board of Governors must take immediate action to make up their shortfall. The Federal Reserve will usually make a short-term loan to a bank in this situation to give the bank an opportunity to make adjustments in its loan and investment portfolio that will permit it to raise its reserves.

The Federal Reserve uses changes in the discount rate as another tool of monetary policy. Raising the discount rate makes it more expensive to borrow from the Fed, and bankers tend to build up their reserve position further above the minimum amount legally required, to guard against the expense of having to borrow money from the Federal Reserve. This conservative policy of banks reduces the volume of the loans they would otherwise be making, and thus an increase in the discount rate tends to cause a decrease in the money stock and higher short-term interest rates.

Conversely, when the discount rate is lowered and the cost of borrowing from the Federal Reserve to meet a temporary emergency falls, bankers are more likely to reduce their excess reserves to a minimum, extending more loans and thus increasing the money stock and tending to lower interest rates in the short term.