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Federal Funds Rate vs. Federal Discount Rate
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The federal funds rate is the interest rate that banks charge other banks when lending money to them. One of the consequences of having a reserve limit is that sometimes banks, in trying to stay as close to that limit as possible, may go under it and thus need to borrow some money to boost their reserves. This rate is set by the Federal reserve.
The federal discount rate is the interest rate that the Fed charges banks when it lends the bank money. This amount is higher than the Federal Funds Rate so it’s used as a last resort for banks needing some cash to boost their reserves.
In an earlier article on how the Fed rate affects the stock market, I made an error of omission by mentioning only the federal discount rate and wanted to take the opportunity to clear that up.
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If the federal funds rate is lower than the discount rate, why would any commercial bank borrow from the Fed and pay the discount rate instead of borrowing from another bank and pay the federal funds rate?
Because the bank has exhausted all other sources of credit, e.g. other banks do not want to lend to this bank for considerations of risk. The Discount Window is then the last resort for the bank to solve the liquidity issues for the short term.
The Federal Funds rate is not SET by the Fed, it is targeted as the Fed cannot legally or direct dictate at what rate banks can lend to each other. The Fed can direct the rate at which banks lend to each other through various Monetary Policy Tools.