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The Discount Rate & Monetary Policy: How Banks Can Borrow Money from the Federal Reserve

The Discount Rate & Monetary Policy: How Banks Can Borrow Money from the Federal Reserve
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  • 0:05 When a Bank's Reserves Fall
  • 2:18 What Is the Discount Rate?
  • 3:23 A Tool of Monetary Policy
  • 4:58 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Learn more about the discount rate, which is the rate that banks pay to the central bank when borrowing money. This lesson explains how changes in the discount rate affect the money supply and how the central bank can use the discount rate as part of monetary policy.

When a Bank's Reserves Fall

The First National Bank of Ceelo has had a great year. Deposits have increased and so have new loans in the community. Businesses have done well, and some business owners have gone from rags to riches, as evidenced by this man, Frohm, who has worked as a Santa Claus during the Christmas season at a commodities trading firm. Frohm used to live in this van down by the river, throwing darts, counting the days and waiting for Christmastime to roll around again and again.

After Frohm completed an economics course on Study.com, he borrowed from the bank to finance a new business he calls Frohm Jon Surfboards. Now he lives in this 20,000 square-foot mansion overlooking the river where his van used to park each night. Sometimes you can catch Frohm sitting by his backyard pool, staring through binoculars toward the river where the tire tracks from his old van can still be seen from afar.

When the First National Bank extended a loan to Frohm, the original amount of the loan was $500,000. After several weeks of negotiations and requests from Frohm, the bank increased this loan amount from $500,000 to $1,000,000. While the bank is happy about the extra interest it will earn from this business loan, they quickly realize that they won't have enough cash on reserve to cover their everyday needs and to comply with regulations from the Federal Reserve, who oversees their operations.

When the First National Bank discovers their reserves have fallen short, they try to borrow money from other banks but are not able to find one that will lend to them.

Jerry, a former rock star with long hair and gigantic Botoxed lips, is the manager of the bank who discovers this urgent matter. To bring their reserves back up to the required levels, Jerry does two things. First, he gets on the loudspeaker and plays a guitar solo. Immediately afterwards, he contacts the Federal Reserve and asks to borrow money from them to increase the reserves of the bank. The interest rate he pays on this loan is called the discount rate. Let's find out more about it and discover how the central bank uses it as a tool of monetary policy.

What is the Discount Rate?

The discount rate is the interest rate charged when member banks borrow directly from the Fed. All banks are required to set aside a certain proportion of their deposits in reserve, according to the reserve ratio set by the Federal Reserve. Throughout the year, a bank may find that their reserves are lower than the amount required. In order to correct this deficiency, the bank typically borrows money from other banks and pays the federal funds rate.

In the event they can't borrow enough from other banks to cover their reserve amount, they always have the option of borrowing directly from the Federal Reserve, in which case they pay the discount rate. That's why the Fed is referred to as the 'lender of last resort.' When Jerry contacted the Federal Reserve, he was quite happy to know that the Federal Reserve will always lend a hand in a crisis situation. The financial system is more stable because of this arrangement - not the music arrangement that Jerry played over the loudspeaker, but the ability to borrow from the Fed at the discount rate.

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