Final answer:
The Federal Reserve encourages banks to borrow by adjusting the discount rate and by setting it higher than the federal funds rate, leading banks to seek other sources first. Banks profit by lending at rates above what they pay for borrowing, like the prime rate over the Fed's rate. The central bank can also create money to influence the banking sector and economy.
Step-by-step explanation:
The Federal Reserve (the Fed) has several mechanisms to encourage banks to borrow money when they desire such an outcome. One method is adjusting the discount rate, which is the interest rate the Fed charges banks for short-term loans.
To borrow from the Fed, banks are expected to seek funds from other sources first, such as interbank lending at the federal funds rate, which is typically lower than the discount rate. By setting a higher discount rate compared to the federal funds rate, the Fed encourages banks to only use the discount window as a last resort for their reserve requirements.
Banks tend to make profits by lending money at a higher interest rate than they pay for it. The prime rate, which is the rate banks charge their most credit-worthy customers, is typically a few percentage points above the Fed's rate. For instance, if the prime rate is at 4%, the Fed's rate might be at 1%. This difference allows banks to cover their costs and generate a profit.
Moreover, the central bank has the ability to create money out of "thin air" when it wants to inject liquidity into the economy, such as through purchasing bonds. This is done by crediting banks' accounts with funds that are essentially newly created, thus increasing the banks' reserves and their capacity to lend.
Lastly, it's worth noting that in recent decades, the reliance of banks on discount window borrowing has declined due to a preference for the more effective open market operations as a tool for conducting monetary policy.