Definition
The discount rate is the interest rate a central bank charges commercial banks when they borrow money directly from it on a short-term basis. In the United States, this lending takes place through the Federal Reserve's discount window.
Banks turn to the discount window when they need reserves quickly and cannot easily obtain them elsewhere. The rate the central bank sets for these loans is one of the levers it uses to influence the cost of credit throughout the economy.
Why it matters
How it works
When the central bank raises the discount rate, borrowing from the discount window becomes more expensive. Banks are encouraged to manage reserves more carefully and to lend less freely, which raises interest rates across the economy and cools demand. Lowering the rate has the reverse effect, making it cheaper for banks to obtain reserves and encouraging more lending. The discount window also plays a stabilizing role: during a panic, it provides emergency liquidity to healthy banks so a temporary cash shortage does not turn into a failure.