Discount Rate
Plain definition
The interest rate the Federal Reserve charges commercial banks for short-term loans of reserves through its discount window.
In economics
The discount rate is one of the Fed's traditional tools: lowering it encourages banks to borrow reserves and lend more, while raising it discourages borrowing. In practice it is a backstop facility, since banks can usually borrow more cheaply from each other in the federal funds market.
Example
A small bank faces unexpected withdrawals and is short on reserves overnight. Rather than sell assets at a loss, it borrows $10 million from the Fed's discount window at the discount rate, repaying it the next day once deposits stabilize.
The discount rate is confused with the federal funds rate. The discount rate is what the Fed charges banks directly; the federal funds rate is what banks charge each other for overnight loans. The funds rate is the Fed's main policy target, while the discount rate is set above it as a penalty backstop.