What is a Bank Rate?
Also called the
How Does a Bank Rate Work?
To understand the bank rate, it is important to understand that banks derive deposits in .
When a bank is unable to meet the reserve requirement, it can borrow those from another bank or directly from the Federal Reserve. Borrowing from the Federal Reserve involves borrowing from 's "Discount Window." The are unsecured and are for very short periods (typically overnight).
An increase in the bank rate discourages banks from borrowing to meet reserve requirements, causing them to build up reserves (and thus lend out less money). A reduction in the bank rate has the opposite effect: It encourages banks to borrow to meet reserve requirements, which makes more money available for lending.
Why Does a Bank Rate Matter?
The Federal Reserve sets the bank rate, and by doing so it influences the rate at which banks also borrow from each other (the federal funds rate, banks probably prefer to borrow from the Federal Reserve when they need . This downward pressure on the federal funds rate.
Conversely, if the bank rate is higher than the federal funds rate, banks probably borrow from each other rather than from the Federal Reserve. This upward pressure on the federal funds rate. In either case, the Federal Reserve can trigger a change in the federal funds rate by changing the discount rate. This is why the bank rate and the federal funds rate are generally closely correlated.
Because the increase in the supply of available for lending puts downward pressure on interest rates, changes in the bank rate can have widespread economic effects. Manipulation of the federal funds rate is one of three primary methods the Federal Reserve uses to control the supply (the other two involve changing and buying or selling U.S. on the ).