Over and over, I hear that the Fed will "raise rates" to dampen inflation. Many reasons exist why rising rates would not, by necessity, affect inflation. In this post, however, I wish to explain why The Fed cannot unilaterally change interest rates.

Diagram of Interest

I will refer to the diagram below in the details of my explanation. This diagram shows the number of units of goods on the vertical axis and time on the horizontal axis.

The Loan

In a loan transaction, one party agrees to give the "borrower" a specified number of units of a current good in exchange for a specified number of units of future goods. The parties may specify the future goods, or they may agree to accept a fungible good - a good with the same characteristics as the current good.

Since goods in the future have less value than goods in the present, the lender will generally ask for more units returned in the future than they provide in the present.

Current Goods

The left side of the time axis indicates the amount of current goods provided by one party in exchange for goods in the future. We generally refer to the current goods as the "principal."

Future Goods

The right side of the time axis indicates the amount of future goods provided by another party in this exchange.

For the sake of explanation, people divide the future goods into two categories: principal and interest. The principal amounts to the same number of units provided as current goods. The interest equals the difference between the total future goods and the amount of principal.

So far, I have mentioned only the amounts of current and future goods. I have made no mention of interest rates.

Interest Rate

The sloping line between the total current goods and the total future goods represents the rate of change in interest. The slope of that line equals the rate of interest. To be precise, the rate of interest to the quantity of goods exchanged with each unit of time. To state it another way, an interest rate would amount to specific units, for example, five units per year or 10 units per year or, if it were a money transaction, $10 per year.

What people frequently refer to as an interest rate really consists of a fractional rate of interest. It consists of the rate of change in interest over time as a percent of principal — e.g., five percent per year or 10 percent per year.

Changing Interest Rate

A person can only determine the rate of interest after the two parties have made a contractual agreement that defines the number of current goods and the number of future goods.

The only ways the rate of interest or the fractional rate of interest can change are to change one or both of the number of current or future goods.

I have described interest in terms of goods rather than dollars because interest can be paid in any good besides money. This distinction becomes important when we consider that money acts as a medium of indirect exchange.

Conclusion

Thus, the Federal Reserve can only influence rates by engaging in transactions that influence the amount of current dollars available or the amount of future dollars available. Clearly understanding how the Federal Reserve goes about influencing interest rates will help you more clearly understand the impact and limitations of this influence.

Remember calculating interest rates requires first knowing the amount of current goods and the amount of future goods.