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The discount rate is the rate of interest the central bank charges commercial banks when they borrow funds directly from it. Think of it as the cost of emergency money. Banks don’t utilize this window for daily operations; they prefer to borrow from each other in the interbank market.
But when liquidity gets tight, the central bank’s discount rate becomes the backup. Changes in the discount rate give indications about where monetary policy is going, since it affects the cost of money at its most basic level.
A higher discount rate usually suggests the central bank is tightening conditions. If it’s going down it’s likely trying to vent pressure in the system.
Example: In the 2008 financial crisis, the Fed aggressively slashed its discount rate and told banks they could borrow freely from its lending facilities. The message was meant to be that the Fed was open for business, liquidity was there, and it was doing everything it could to stave off a complete freeze in the banking system.
