Now let’s talk about the first tool that the Federal Reserve has to help the economy, and that’s by changing the discount rate. The Federal Reserve can increase or lower the discount rate. What is the discount rate? The discount rate is the rate that banks can borrow from the Federal Reserve.

Banks constantly bring in a lot of money and spend a lot of money. Sometimes they need to borrow money. When banks borrow money, they typically borrow from the Federal Reserve, and the interest rate they pay is the discount rate. Whenever the discount rate increases, then it’s more expensive for the bank to borrow money from the Federal Reserve.

The prime rate is what the banks charge to their customers, which is higher than the discount rate because the banks need to make a premium on their interest rates. Let’s say that the Federal Reserve is charging a discount rate of 2%, and then banks are going to create a profit of 3% and therefore charge a prime rate of 5%.

Let’s think about how this impacts the economy. Let’s say that there’s too much economic activity. The Federal Reserve wants to decrease economic activity. Therefore it can increase the discount rate. This causes the prime rate to increase as well. Therefore, it’s going to be more expensive to borrow money, and companies will be disincentivized to borrow. Therefore, they will borrow less and spend less. This will cause the money supply to decrease. This is how the discount rate affects the economy.

Study Tip: Raising the discount rate decreases money supply and decreases economic activity. Decreasing the discount rate increases the money supply and encourages economics activity.

Summary of Changing the Discount Rate

If the Federal Reserve decides to raise the discount rate, then the prime rate’s going to increase, which is the rate that businesses get to borrow at. Then, businesses will borrow less if it’s more expensive to borrow, resulting in less money available in the money supply. If businesses borrow less, they will spend less on their businesses. They will consequently spend less on hiring, causing unemployment to increase

If fewer people have jobs, they have less available income to spend. This is the full impact of raising the discount rate.