Inflation and the Federal Reserve
Well done. As we have learned, the Federal Reserve is extremely important in deciding and implementing economic policy in the US. The primary mechanism used by the Fed to implement its policy is called "open market operations." Open market operations are simply the New York Bank of the Federal Reserve either selling or buying government bonds to or from large banks.
If the Fed buys a bond it credits the account of that bank. This increases the amount of money available to that bank to make loans. The bank lends the money to someone, who uses it to purchase some product. The seller of the product deposits the money in her bank. That increases the money her bank has to lend, and we have the US money supply increasing with the added kicker of what we call the multiplier effect. If the multiplier is 10, then the Fed's purchase of a $1 million bond will increase the US money supply by $10 million.
To shrink the money supply, the Fed will sell government bonds to large NY banks. The multiplier works in reverse. If the multiplier is 10, then the sale of a $1 million bond will reduce the US money supply by $10 million.
You are probably wondering why the articles you read discussed the Fed Funds rate (interest rate at which banks lend to each other overnight), instead of discussing the money supply. This is because the Fed closely watches the Fed Funds rate to determine the effect that its open market operations are having on the economy.
Interest rates are simply the price of money. If you want to buy some money so you can buy a car, the bank sells you $20,000 today for $20,000 plus 10% interest to be paid back over 3 years. The 10% is the price you pay for the use of the money. As we have learned, prices are determined by supply and demand. While the Fed has tools to directly effect and measure the money supply, it can only indirectly measure the demand for money. Thus, by watching the price of money, in this case the Fed Funds rate, it can indirectly measure the demand for money as well as the money supply.
When too many dollars chase too few goods, the result is inflation. You can think of the economy as having two halves, which are mirror images. The real economy half is all the goods and services out there to be bought and sold, and the monetary half is the money with which each transaction is conducted. If the monetary half expands more rapidly than the real half, the number of dollars per unit of the real economy increases. This is inflation. Thus if $1 represented a hamburger on day one and the money supply doubled that night, then $2 would represent a hamburger on day two. It is actually a little more complicated than this, but you get the idea. The formula used to represent this point is MV=PT. MV (money supply X velocity of money) is the monetary half of the economy. PT (average price X total number of transactions) is the real half of the economy. Here is a short article, which explains this important formula. http://stlouisfed.org/publications/re/2007/c/pages/pres-mes.html