Final answer:
The discount rate is the rate the Federal Reserve charges banks for direct loans, while the federal funds rate is the rate banks charge each other for overnight loans. The Federal Reserve encourages use of the federal funds rate over discount loans by setting the discount rate higher, and changes in the federal funds rate have broader economic implications.
Step-by-step explanation:
The discount rate and the federal funds rate are both tools of the Federal Reserve's monetary policy but differ primarily in their usage and the entities they directly affect. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility, often used as a last resort. In contrast, the federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
The Fed encourages banks to seek loans from other institutions at the federal funds rate before using the discount window, which typically has a higher rate, to maintain required reserves. Changes in the federal funds rate can affect economic variables, including other interest rates, money and credit supply, and can have broader economic impacts, whereas the discount rate mainly influences the borrowing cost for banks directly from the Fed.
Since most banks primarily borrow at the federal funds rate rather than the discount rate, changes in the discount rate have less impact on their behavior. Furthermore, the Fed uses open market operations, which involve buying and selling government securities, as a more effective tool for steering economic policy.