When banks loan money, that money is spent on goods or services. These goods or services create income for the people providing them, which they in turn spend on other good and services. When lots of loans are made, even more spending is done and more money is pumping through the economy.
When the Fed sees that too much money is going through the economy and prices are rising too quickly (inflation), they put the brakes on by selling securities. This reduces the amount of reserves available to banks, causing interest rates to rise, and banks will not make as many loans because it costs more for consumers to borrow. Ultimately, the economy slows down and inflation slows down with it.
The Fed Tool Box: The Discount Rate
The "discount rate" is the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis. The Fed discourages banks from borrowing except for occasional, short-term emergency needs.
The discount rate often plays a larger role in the overall monetary policy than would be expected because it is a visible announcement of change in the Fed's monetary policy. Typically, higher discount rates indicate that more restrictive monetary policies are in store, while a lower rate might signal a less restrictive move.
Changes in the discount rate can affect:
- Lending rates (by making it either more or less expensive for banks to get money to lend or hold in reserve)
- Other open market interest rates in the economy (because of its "announcement effect")