Although most interest rates are determined by the forces of supply and demand m the money or capital markets, one important interest rate—the discount rate—is not. This rate is an administratively determined rate charged by the Fed to banks when they borrow reserves from the Fed. This borrowing is supposed to be for seasonal and emergency needs, but because this rate is usually below going market rates, banks find it profitable to borrow at the discount window even when they are not in need of reserves. The Fed discourages such borrowing, however since it dilutes Fed control over the money supply.

Although a higher discount rate should discourage bank borrowing from the Fed and thus decrease the money supply, this is a very inefficient way of affecting the money supply and is not used for this purpose. The Fed changes the discount rate from time to time mainly to give a signal or announcement to markets concerning the Fed s intentions regarding interest rates. Such changes usually follow changes in market rates and serve to indicate that the Fed views these market rate changes as permanent.

When the Fed focuses on an interest rate instead of a monetary aggregate to conduct monetary policy, it uses the federal funds rate instead of the discount rate. The federal funds rate is the rate charged by one bank to another for borrowing (usually overnight) some of its excess reserves at the Fed. Commercial banks that are unable to meet their legal reserve requirement borrow other banks excess reserves, paying the federal funds rate, determined by the forces of supply and demand in this market.

The advantage to the Fed of focusing on the federal funds rate is that it is determined by supply-and-demand forces and thus is a good indicator of the “tightness” of current monetary policy insofar as market interest rates in general are concerned. Suppose the Fed buys bonds on the open market and thereby increases reserves in the banking system. As a result, few commercial banks will be unable to meet their reserve requirement, and many banks will have excess reserves. Demand for excess reserves will be low and supply high, so the federal funds rate—the “price” in this market—will be low. Furthermore, we can expect this low federal funds rate to spread quickly to the economy at large; the excess reserves that have created the low federal funds rate will cause banks to increase loans and thereby to lower interest rates in general.