The basic business of banking involves taking money into certificates of deposit and checking and savings accounts and lending it out at higher interest rates while maintaining federally mandated reserves. Because a bank's balances of checking and savings account money fluctuate, as do loan fundings, sometimes a bank has more money going out than coming in, or vice versa, and must borrow from the Federal Reserve at the discount window to maintain required reserve ratios.
The Fed Discount Window
The Federal Reserve is the banker's bank. This is where banks keep their reserve money. When they experience unexpected outflows in transaction accounts or have too many loan fundings and find their reserves do not cover the federal requirements, the discount window is available to loan emergency funds. The Fed charges interest on those loans at the discount rate.
Loans and the Money Supply
When a loan is made, it increases the money in circulation, which is referred to as the nation's money supply. In a booming economy, lots of loans are made and the money supply grows too much, which causes inflation. The Fed controls inflation by removing money from the money supply by raising the discount rate and, occasionally, bank reserve requirements. Raising reserve requirements lowers the amount of lendable funds in banks. Raising the discount rate makes it less profitable for banks to lend, so they raise the interest rates they charge on loans, and this discourages borrowing and slows or stops the growth of the money supply.
Lowering the Discount Rate
During a slow economy, the Fed encourages growth in the economy and the money supply by reducing reserve requirements and lowering the discount rate. This normally encourages banks to lower the rates they charge on loans, which increases borrowing. When the reserve requirements are also loosened, banks have more money available and increase their lending activities. They are normally glad to do this, because the return on lending is traditionally how they make profits. During periods when their loan production is low, banks resort to increasing fees on accounts and selling fee-based services to make money.
When interest rates are at historically low levels, as happened after the credit crisis of 2008, even lowering the discount rate and reducing reserve requirements don't encourage banks to lend. This is because lending incurs risk that the loans will not be repaid, and low interest rates on loans do not compensate the banks for taking on the risk of lending to any but the most creditworthy borrowers. This "liquidity trap" can drag out the effects of a recession.
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