When a central bank changes its discount rate, the interest rate it charges for loans to other banks, interest rates across the economy almost always follow suit. For example, the interest rate on loans made between banks — called interbank rates in Europe and Fed funds rates in the United States — will rise whenever banks have to pay more to borrow from the central bank and will fall when they have to pay less. The higher cost of money is almost always passed on to consumers and businesses in the form of higher interest rates on every other form of loan in the economy.


What is the difference between the discount rate and the Fed funds rate?

Think of the strange fact that the discount rate is set by the Federal Reserve and the Fed funds rate isn't. The discount rate is the interest rate that the U.S. Federal Reserve, America's central bank, charges on loans to member banks. This rate is set periodically by the Fed in an attempt to influence interest rates throughout the economy, thus allowing the Fed to control economic growth. The Fed funds rate is interest that banks charge on overnight loans to other banks. It's called the Fed funds rate because the money being loaned between banks is usually kept at the Federal Reserve. Although heavily influenced by the Fed's policies, the Fed funds rate is actually set by the banks themselves.

All interest rates are linked because money, like most commodities, is interchangeable. Banks and individuals will go wherever rates are lowest — wherever money is cheaper. A change in interest rates by the Federal Reserve in Washington, for example, will not only affect consumer and business loan interest rates in Miami or Minnesota, but now affect interest rates around the world. And the actions of central banks around the world increasingly are affecting domestic rates in the United States. In the global village of international money markets, interest rates have become the heartbeat of economic activity — and the world's economies are increasingly interconnected.

Perhaps the most dramatic way for a central bank to increase or decrease the money supply is through open-market operations, where a central bank buys or sells large amounts of securities, such as government treasury bonds, in the open market. By buying a large block of these bonds from a bank or securities house, the central bank pumps money into the economy, freeing up funds that were not previously part of the economy's official money supply — making those funds available for the banks selling the bonds to lend out to consumers and businesses.

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