"The Federal Reserve is raising interest rates to reduce inflation."

[sevensages]

A few years ago I was talking to another trucker in the driver's lounge at a truckstop about inflation. This other trucker said that the Federal Reserve is raising interest rates to reduce inflation. At the time, I didn't know that raising interest rates would cause inflation to decrease, and I only focused on that fact. But later on something else occurred to me, I don't know what the heck that the statement that the Federal Reserve raised interest rates means exactly. I will put my supposition on how this works in green text. My supposition is that maybe the fact that the Federal Reserve raised interest rates means the following: The Federal Reserve loans money to banks for the purpose of adding currency into the circulation. If the Federal Reserve raises interest rates, it just means that the banks that the Federal Reserve loans money to have to pay the loan back to the Federal Reserve at a higher interest rate.

Is my supposition correct?

 

[Astronuc]

If the Federal Reserve raises interest rates, it just means that the banks that the Federal Reserve loans money to have to pay the loan back to the Federal Reserve at a higher interest rate.

Is my supposition correct?

One's supposition is correct, but it is more complicated than just the backs. The banks and other financial institutions raise downstream interest rates, which in theory discourages borrowing, which discourages purchasing (consumption), which in theory leads to lower prices as sellers reduce prices to sell to reluctant buyers. In reality, it doesn't necessarily work that way, especially if the markets are not competitive, or if the bulk of the economy is highly leveraged, as in much of the economy functions on credit.

In some situations, if the Federal Reserve raises interest rates, the action may exacerbate inflation. If interest rates function as feedback in the economy, and raising interest rates is considered negative feedback (deflationary), then under what conditions can raising interest rates become positive feedback (inflationary)?

 

[sevensages]

One's supposition is correct, but it is more complicated than just the backs. The banks and other financial institutions raise downstream interest rates, which in theory discourages borrowing, which discourages purchasing (consumption), which in theory leads to lower prices as sellers reduce prices to sell to reluctant buyers. In reality, it doesn't necessarily work that way, especially if the markets are not competitive, or if the bulk of the economy is highly leveraged, as in much of the economy functions on credit.

In some situations, if the Federal Reserve raises interest rates, the action may exacerbate inflation. If interest rates function as feedback in the economy, and raising interest rates is considered negative feedback (deflationary), then under what conditions can raising interest rates become positive feedback (inflationary)?

I don't know what conditions could cause raising interest rates to exacerbate inflation.