Final answer:
The discount rate puts an upper limit on interest rates for borrowing reserves under an ample reserves regime, as banks will normally avoid borrowing from the Federal Reserve at a higher rate when they can borrow at the fed funds rate from other banks.
Step-by-step explanation:
The discount rate places an upper bound on the interest rate that banks will pay to borrow reserves under an ample reserves regime. Banks are expected to borrow from other sources, such as other banks, before approaching the Federal Reserve for reserves. The Federal Reserve sets the discount rate typically higher than the fed funds rate. This high discount rate discourages banks from borrowing directly from the Fed unless necessary. As a result, most banks choose to borrow at the typically lower federal funds rate in the open market, thus establishing an upper limit on the interest rates banks are willing to pay when borrowing reserves.
By setting a higher discount rate, the Federal Reserve ensures that banks will not borrow from the discount window unless the fed funds rate is even higher, effectively putting a ceiling on the fed funds rate as well. It's important to note that open market operations have been found to be a more powerful tool compared to changing the discount rate.