What Happens When the Central Bank Raises the Discount Rate?

A central bank plays an important role in managing a country’s economy through its monetary policy tools. These tools influence the availability and cost of money and credit to promote economic stability. One such tool is the discount rate, an interest rate that impacts financial institutions. By adjusting this rate, the central bank can steer economic activity to achieve stable prices and sustained economic growth.

Direct Impact on Commercial Banks

The discount rate is the interest rate a central bank charges commercial banks when they borrow money from it. This borrowing occurs through a facility known as the “discount window.” Banks use the discount window to address short-term liquidity needs, such as managing cash flow imbalances or meeting reserve requirements.

When the central bank increases the discount rate, it raises the cost for commercial banks to borrow these funds. This makes it more expensive for banks to obtain the liquidity they need from the central bank. Consequently, banks become more cautious about lending money, as their own cost of funds has increased.

This increased borrowing cost for banks can influence their decisions regarding their lending rates and the amount of credit they extend. While the discount rate is set higher than the federal funds rate (the rate banks charge each other for overnight lending), it serves as a ceiling for short-term interbank rates. A higher discount rate signals a more restrictive monetary policy, pushing up the overall cost of short-term funding for banks.

Consequences for Borrowing and Spending

The increased cost of borrowing for commercial banks translates into changes for consumers and businesses. Banks often respond by adjusting the interest rates they charge on various types of loans. This includes consumer loans such as mortgages, auto loans, and credit card balances, making them more expensive.

For consumers, higher interest rates reduce the appeal of financing large purchases. The monthly payments on a new home or car become larger, potentially deterring taking on new debt. This can lead to a decrease in consumer spending, as households may delay discretionary purchases or save more to earn higher returns on deposits.

Businesses also face higher borrowing costs when the discount rate rises. Loans for expansion, equipment purchases, or working capital become more expensive, impacting their profitability and cash flow. This can lead companies to reassess or delay investment plans, prioritize projects with quicker returns, or explore alternative financing options. Reduced business investment can slow economic growth and affect hiring decisions.

Influence on Inflation and Exchange Rates

The macroeconomic effects of a higher discount rate extend to inflation and exchange rates. When the cost of borrowing increases for both consumers and businesses, it leads to reduced spending and investment. This slowdown in economic activity can cool an overheating economy and curb inflationary pressures. The central bank uses this mechanism to manage the money supply and stabilize prices.

A higher discount rate also influences exchange rates by making a country’s financial assets more attractive to foreign investors. Higher interest rates offer better returns on investments, drawing in foreign capital. This increased demand for the national currency can lead to its appreciation, making it stronger relative to other currencies. A stronger currency can then make imports cheaper and exports more expensive, impacting domestic prices and international trade balances.