Federal Funds Rate vs. Federal Discount Rate

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The federal funds rate is the interest rate that banks charge other banks when lending money to them. One of the consequences of having a reserve limit is that sometimes banks, in trying to stay as close to that limit as possible, may go under it and thus need to borrow some money to boost their reserves. This rate is set by the Federal reserve.

The federal discount rate is the interest rate that the Fed charges banks when it lends the bank money. This amount is higher than the Federal Funds Rate so it’s used as a last resort for banks needing some cash to boost their reserves.

In an earlier article on how the Fed rate affects the stock market, I made an error of omission by mentioning only the federal discount rate and wanted to take the opportunity to clear that up.

{ 7 comments, please add your thoughts now! }

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7 Responses to “Federal Funds Rate vs. Federal Discount Rate”

  1. Ken says:

    If the federal funds rate is lower than the discount rate, why would any commercial bank borrow from the Fed and pay the discount rate instead of borrowing from another bank and pay the federal funds rate?

  2. Denis says:

    Because the bank has exhausted all other sources of credit, e.g. other banks do not want to lend to this bank for considerations of risk. The Discount Window is then the last resort for the bank to solve the liquidity issues for the short term.

  3. Chris says:

    The Federal Funds rate is not SET by the Fed, it is targeted as the Fed cannot legally or direct dictate at what rate banks can lend to each other. The Fed can direct the rate at which banks lend to each other through various Monetary Policy Tools.

    • jamesheng says:

      You are right, and Jim was wrong. The Fed only influences the fed rate (via discount rate, open market ops and reserve requirement), not directly set it.

      • Jim says:

        You are correct, this post was written years ago before I fully understood how it worked. The Fed doesn’t directly set the rate but it controls all the other factors so it effectively sets it (or in its words, sets the target).

  4. Manny says:

    Federal Funds Rate is such a misleading name. It’d make more sense if called the Inter-Banks Rate or something close to that. Thank you guys for your feedback! =)

    • jamesheng says:

      I guess, the reason why it is called fed funds rate because the “money” – the excess reserves used for interbank-lending, is kept at the Fed.

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