The relationship between the Federal Reserve System, interest rates, and inflation is a complicated matter. The actual economics involved is rather simple; the systems and policies, however, are absolutely convoluted. If you can understand this system, you'll basically be at the cream of the crop as far as understanding economics goes.
There are a series of steps to getting interest rates and inflation. You have to be familiar with a few things first.
1: Money Supply and its Modification.
In the United States, we have fiat money. It is redeemable for nothing; it simply exists by decree. That means the government can change the total supply of money by printing it or burning it.
Of course, that's too literal. Our banking system is almost entirely electronic, so money "supplies" can be increased our decreased by artificially increasing the money in an account on the Federal Reserve's computers.
When the government wants to increase or decrease the money supply, it uses Open Market Operations. The Federal Open Market Committee (a department of the Federal Reserve System) buys and sells securities. If it buys them, it prints new money to buy them, which puts fresh new cash in circulation. If it sells them, it takes the money it earns from the sale, and destroys it (e.g., it sells $1000 dollars of securities, then destroys the $1000 it earns). This is what most people think of when they think of inflation: the printing press.
Securities are complicated. If you want, I'll send you another message explaining them, or you could Google them.
2: Reserve Requirements.
What happens when a bank is out of reserve funds? It's clients want their deposits, and there is a bank run. So, the Federal Government requires that banks keep a certain portion of all the money they loan out in reserve at the Federal Reserve. This percentage is typically 10%. If a bank loans out 1 million dollars, it must keep one hundred thousand dollars in reserve at the Federal Reserve.
3: The Federal Funds Rate.
What if a bank doesn't have enough money to meet its reserve requirements? It has to borrow the extra cash from a bank that has more than enough. Bank A is $1000 short of its reserve requirement, so it borrows $1000 from bank B.
That's one option. The other I'll discuss in a minute.
Those two banks privately negotiate the interest rate of the loan. The government doesn't "tell them" what to charge. But, like anything, this interest rate is affected by supply of and the demand for money. Therefore, the supply of money affects what this interest rate will be.
The "federal funds rate" is the average interest rate that banks charge each other for these loans. You take all the loans of such a type which happen, and average the interest rates out over a two-week time period to get the federal funds rate.
4: The Discount Rate
The discount rate is the interest rate that the Federal Reserve that itself charges banks to borrow money to meet their reserve requirements. This rate is usually about 1 percentage point higher than the federal funds rate. This way, banks are able to borrow money to meet their most urgent needs in an absolute emergency, but the interest is a little higher so they generally avoid it. The Fed is a lender of last resort. This provides a security blanket, in case of disruptions in normal affairs which may prevent banks from even loaning to each other, if they are all short of funds.
5: The Federal Funds 'Target' Rate.
This is the "interest rate" you always hear about.
It isn't a rate the government "creates"; rather, it is their "goal" for what the federal funds rate "should" be. They set a range within which they want the interest rate to fall. Right now, that goal is 0-0.25% percent (the government is trying desperately to stimulate economic activity. A word on that in a minute).
The Federal Open Market Committee manipulates the money supply in order to manipulate the actual federal funds rate, in order to make it closer to the target rate.
This is basic supply and demand. An interest rate is the price of money. When the supply of money is increased, the interest rate goes down. When supply is diminished, the interest rate goes up. That's how the open market committee manipulates the federal funds rate without "forcing" it to be a certain rate.
6: Effects on Lending.
This is where cause and effect plays a big role. When a bank has cash, it can either store that cash in the reserve, or loan it out for profit. If the federal funds rate is low, then the bank will lend out lots of money, because it can cheaply borrow all the money needed to meet its reserve requirement. This lowers the interest rates that banks charge consumers and businesses; it makes them more willing to lend money.
When the federal funds rate is expensive, then banks will keep more cash in the reserves by lending less money, because borrowing reserve cash from other banks becomes too expensive. This discourages lending to consumers and businesses.
The discount rate is actually set by the federal reserve, and it plays a similar role, but only in emergencies like bank runs. Because banks can normally secure lower rates from other sources, they disregard the discount rate. When they cannot secure cheaper loans in crises, the discount rate matters.
7: Why Lending Matters.
Lending matters because (according to the economic model the Federal Reserve buys into) it stimulates economic activity. The more money gets loaned out, the more people buy, the more stuff gets built, etc. The more economic activity there is, the higher prices will be. If everyone goes out and starts buying houses, the price of houses will go up, REGARDLESS of the money supply. More on that in a minute.
8: A Word on Inflation.
Inflation simply means that prices are rising. This can be caused by two things:
a) An increase in the money supply. People have more money, so they spend more. To deal with the increased demand, entrepreneurs raise prices. That maximizes their profit and prevents the supply from running out.
b) A general increase in aggregate demand. When, for some reason, the population in general starts to spend much more money much more quickly, prices will rise to deal with the increase in demand.
However, many economists argue that at the root, all inflation is due to changes in the money supply. Milton Friedman famously said that "Inflation is always and everywhere a monetary phenomenon." There is an entire branch of economic thought, monetarism, which is focused on monetary policy.
9: Summary
The Federal Open Market Committee (which is part of the Federal Reserve) creates or destroys money by buying or selling securities, in order to affect the money supply. That IN ITSELF causes inflation.
It manipulates the money supply in order to affect the federal funds rate, which affects how much banks lend.
By affecting how much banks lend, the Federal Reserve affects the economy by either stifling or boosting economic activity.
The amount of economic activity is the more significant element of inflation. It makes prices rise by boosting aggregate demand.
10: You, my friend are now very highly educated about monetary policy.
11: End the fed.
