Why does the Fed not use the discount rate to conduct monetary policy? How does the...

Why does the Fed not use the discount rate to conduct monetary policy? How does the Fed use the discount rate?

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Expert Solution

Discount rate is the rate at which commercial banks borrow money from the Federal Reserve directly. It is similar to the Fed fund rate, where money is borrowed from other commercial banks at Fed fund rates. Commercial banks are required to maintain a reserve fund, if it fall short of it, banks borrow money from other banks with surplus fund at Fed fund rates. If it borrows directly from the Federal Reserve then Federal Reserve grant loan at the discount rate. Therefore, Discount rate is always higher then the Fed Fund rate.

Discount rate is a tool Federal Reserve uses to influence the monetary policies. Lowering the discount rate will influence other interest rates which will encourage more lending and spending by individuals and businesses, which eventually effects the growth in employment rates and boosting the economic growth. Likewise, higher discount rate will slow down the economy growth to curb inflation.

Thus, borrowing money from Federal reserve at a discount rate is a last resort to commercial banks as the discount rate is higher than the Fed fund rate which will influence other monetary policies.

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