Final answer:
An increase in the discount rate by the central bank leads to an increase in market interest rates. This occurs as commercial banks face higher borrowing costs from the central bank, hence lending less and causing the money supply to decrease.
Step-by-step explanation:
When the central bank decides to increase the discount rate, the correct answer is that interest rates increase. The mechanism behind this is tied to the cost at which commercial banks can borrow from the central bank. When this rate is increased, banks have a higher cost for obtaining funds, and thus, they lend less. With fewer loans available, the money supply contracts and, as a consequence, market interest rates go up.
This movement is explained by the relation between the central bank's policy actions and the supply curve of loanable funds. A higher discount rate makes it more expensive for banks to borrow from the central bank, so they in turn lend less or at higher rates. It should also be noted that while the discount rate is a tool for conducting monetary policy, it is not the only method for affecting market interest rates. Open market operations are frequently used by central banks as a more precise mechanism for controlling interest rates and managing the money supply.