What Is Discount Rate Policy Of Federal Reserve Banks?

When commercial banks are short of reserves, they re allowed borrowing from the Federal Reserve Banks. Their loans are included under the asset heading "Loans and acceptances" in the Federal Reserve balance sheet. These loans are called borrowed reserves. When borrowed reserves are growing, the banks are borrowing from the Federal Reserve, thereby increasing total bank reserves. Conversely, a drop in borrowed reserves promotes a contraction in total bank reserves.

In the early years the discount window was the primary vehicle for providing reserves to the banking system. As financial markets developed and the role of monetary policy was better understood, the Federal Reserve has turned to open market operations as the primary tool for adjusting the overall level of reserves. Today, the discount window is used primarily to buffer the day-to-day fluctuations in reserves.

Because banks can go to the discount window when there are unanticipated fluctuations in required reserves, the extent of short-term volatility in interest rates is reduced. Today the discount rate is a relatively minor instrument of momentary policy. Sometimes a change in the discount rate is used to signal markets of a major policy change.