Legal Definitions - rediscount rate

The rediscount rate is the interest rate at which commercial banks can borrow money from a central bank (such as the Federal Reserve in the United States). This borrowing typically occurs when commercial banks "resell" or "rediscount" eligible short-term financial instruments, like promissory notes or bills of exchange, that they had previously discounted for their own customers. Essentially, the central bank acts as a lender to commercial banks, providing them with liquidity by purchasing these assets at a further discount.

This rate is a crucial tool used by central banks to:

• Influence the overall money supply in the economy.
• Impact other interest rates that commercial banks charge their customers.
• Act as a "lender of last resort" to ensure the stability of the financial system.

Here are some examples illustrating the application of the rediscount rate:

• Economic Stimulus: Imagine a country facing an economic downturn, with businesses struggling to invest and consumers reducing spending. To encourage economic activity, the central bank might lower the rediscount rate. This makes it cheaper for commercial banks to borrow funds from the central bank. With lower borrowing costs, commercial banks are more likely to reduce the interest rates they charge their own customers for loans, making it more attractive for businesses to expand and for individuals to take out mortgages or car loans. This increased lending and spending can help stimulate the economy.

• Controlling Inflation: Conversely, if an economy is experiencing rapid price increases (inflation) and is at risk of overheating, the central bank might decide to raise the rediscount rate. This makes it more expensive for commercial banks to obtain funds from the central bank. Consequently, commercial banks may increase their own lending rates to customers, making borrowing less appealing. This reduction in the availability and affordability of credit helps to slow down overall spending and investment, thereby working to curb inflationary pressures.

• Managing Bank Liquidity: Consider a situation where a large commercial bank experiences an unexpected and significant outflow of deposits over a short period, leading to a temporary shortage of readily available cash (liquidity). To meet its immediate financial obligations and maintain stability, the commercial bank can turn to the central bank. It can present eligible short-term commercial paper it holds from its corporate clients and "rediscount" them with the central bank at the prevailing rediscount rate. This provides the commercial bank with the necessary cash to cover its obligations, demonstrating the central bank's role in providing emergency liquidity to the financial system.