The Discount Rate is the interest rate that central banks (like the Central Bank of Nigeria, the Federal Reserve for the U.S., or Bank of England) charge commercial banks or financial institutions when they borrow money directly from the central bank.

Note that it is very different from the interest rate that your normal banks charge individuals or businesses. This basically affects big financial institutions and the overall economy.

Why Do Central Banks Use the Discount Rate?

Central banks do use the this mostly to control monetary policy. The discount rate is a very powerful tool to influence the availability and cost of money in the economy.

Here’s why central banks use it:

To control inflation: If prices of goods and services rise too much (inflation), the central bank will increase the  rate. This action will make loans expensive for banks, so they’ll no longer go borrow a lot of money. 

When banks don’t have enough to lend out, businesses and consumers will borrow less, and money flow for the economy will reduce. This action slows the impact of inflation.

To stimulate growth: If the economy slows down (recession), central banks will reduce the discount rate. This will make borrowing cheaper for commercial banks. Banks go will pass this benefit to businesses and individuals with lower interest rates, boosting spending and investments.

Types of Discount Rates

 There are different ways central banks apply this rate and this includes the following listed below:

• Primary Discount Rate: This discount rate is considered if a bank has a well-performing track record with no credit issues. They are charged the lowest rate by the central bank. This is known as the primary discount rate.

• Secondary Discount Rate: This one is a bit higher than the primary rate. It is for banks that do not meet all the conditions for primary lending. Central banks see them as slightly risky borrowers.

• Seasonal Discount Rate: Some banks in the rural or agricultural areas might need short-term loans during planting or harvest seasons. This special rate is set to help their unique needs.

 How Does It Work?

Let’s use a typical example of what happens regularly

Assuming a commercial bank (like Access Bank or GTBank for Nigeria) is short on cash because a good number of their customers have withdrawn money and they don’t have enough reserves (cash backup) to cover everything. Instead of disappointing their customers, they’ll go to the Central Bank of Nigeria (CBN) to borrow money.

If the rate at that time is 10%, the bank will pay that 10% interest on the loan they collect. This rate is what we call the “discount rate.”

How It Affects the Economy

This influences many parts of the economy, and they influence in the following ways:

Interest Rates in the Market: If CBN increases the rate, commercial banks will increase their own lending rates to businesses and individuals because borrowing has cost them more. This thing will discourage borrowing and reduce spending.

Inflation Control: Higher discount rates reduce money flow in the economy, helping to keep inflation in check.

Economic Growth: Lower discount rates make borrowing cheaper for everyone, leading to increased spending and investment, which boost the economy.

Key Example

Let’s say:

CBN set the discount rate at 12%.

Access Bank borrowed the sum of ₦1 billion from CBN. Access Bank must repay ₦1 billion plus 12% interest (₦120 million), making total repayment ₦1.12 billion.

Access Bank will likely increase their own loan interest rates to cover that cost, making loans more expensive for businesses and individuals. If this happens across many banks, borrowing will slow down and economic activity too.

Frequently Asked Questions

• How is the discount rate different from the federal funds rate?
  While both are interest rates set by central banks, the discount rate is the rate at which banks borrow directly from the central bank. In contrast, the federal funds rate is the rate at which banks lend to each other overnight.
  Investopedia
• Why do changes in the discount rate matter to forex traders?
  Changes in the rate can influence a country’s currency value. An increase may lead to currency appreciation due to higher returns on investments denominated in that currency, while a decrease can have the opposite effect.
  
• How often do central banks change the discount rate?
  There is no fixed schedule for changes; central banks adjust the rate in response to economic conditions and policy objectives.

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