The Fed plays an additional role that can have a major impact on the financial markets and the economy as a whole. It serves as the lender of last resort, providing liquidity in a potential financial emergency.
Here’s how it works. Banks can borrow money from what’s known as the Fed’s discount window, at the discount rate. The Fed sets that rate, which is not driven by supply and demand, at about 0.5% below the federal funds rate.
While borrowing from the Fed is cheap, banks usually avoid it if they can, because it signals that they are in financial difficulty, probably serious enough so that other banks won’t lend to them. But this last-ditch borrowing may prevent bankruptcy or keep depositors from rushing to withdraw their money.
Further, if a major financial institution is in serious trouble, the Fed may help to engineer a rescue if it believes that allowing the institution to fold would have potentially disastrous consequences.
One criticism of the Fed’s being available to bail banks and others out is that it can encourage risky behavior. But, on the other hand, Fed lending during September 2001 helped to keep the financial markets stable until their back-office systems were back in place.
