Abstract theory tells us that interest rates affect people and institutions but in my experience, (which is admittedly limited) I can't see how they do this.
Obviously the rate of interest encourages people to leave more money in the bank rather than less, however I'm not sure how that fact concretely translates into employment/unemployment or depressions/booms? For instance, the construction industry is greatly influenced by interest rates but I don't see lots of hard-hatted construction workers in banks taking out loans so I have no concrete mechanism for how this happens.
Also, how does the FED enforce its decrees on what number the interest rate should be?
I see that Jon Catalan is about to respond, so I'll keep my response short:
1) Look into the Austrian Theory of the Business Cycle. Bob Murphy has written some nice short articles explaining it.
2) Hard-hatted construction workers are not entrepreneurs.
Joseph Salerno speaking:
But the Fed does not directly set interest rates. This is the great modern myth, which was designed to conceal the Fed's true modus operandi. The Fed influences interest rates by creating and injecting dollar reserves into the banking system. The additional reserves increase the supply of loanable funds relative to the economy's demand and thus induce banks to offer loans at lower interest rates in order to attract borrowers for the additional funds. So causation runs from the increase in Fed–created base money to reduced interest rates. Lower interest rates are just one of the distortions caused by the Fed's unrestrained power to create money ex nihilo.
And what really counts is the increase in the money supply, aka inflation. It fools everyone. Suddenly, everyone is rich, it looks like. Everyone spends more, because there is more money to spend.
Unfortunately, production has not increased, so true wealth has not increased. It looks like we are richer, but we are the same as ever. What happens is comparable to a farmer who thinks he has ten new chickens. He decides to throw a big party, main course, chicken. After all, he thinks, the amount of eggs laid is going to stay the same. I'm not eating any of my old supply of trusty egg laying chickens, only these new, extra ones. But in reality there are no new ones. He's eating his egg laying chickens. He is getting poorer to the exact extent he thinks he is richer.
The technical term for this is capital destruction, which hurts everyone.
The role of the interest rate is a very technical one, basically a detail of the big picture. Mises explained how this illusion of wealth causes a lower interest rate, which in turn encourages capital destruction.
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It's easy to refute an argument if you first misrepresent it. William Keizer
Actually, the Fed (and other central banks in other countries) can set the discount (a.k.a "short" a.k.a. "overnight") rates. They can also set the fractional reserve ratio for all banks in the system as another tool for monetary policy. But generally they go for open market operations, that is buying bonds or other assets directly in the financial market with (newly created money), or selling assets and erasing money (out of the system).
Buying bonds raises their prices, which means lower interest rates (remember that the interest rate curve is inversely related to the price of a long term obligation).
And selling bonds has the opposite effect.
There's no myth, everybody with basic macro education knows this. Most people don't understand/care about it, but most people don't understand/care about most things.
But who are the bond-sellers? Who are the first recipients? I suppose banks are? Who are the entrepreneurs of the construction industry? Why would any business go out of business if they could lobby government for support? How is it that the debts of banks end up affecting everyone (for instance, you would think that these debts would only affect parties to a loan and banking employees not construction, retail, etc. leading to a general depression)?
What's everyone's motivation?
There's no myth...
Did you even read the OP? What did he think? Hint: His last line.
Fakename,
Consider the role of prices. The ex post role of prices, profit and loss, is signalling, where losses imply overinvestment and profits imply underinvestment. The ex ante role of prices is to help individuals allocate their means towards their preferred ends. In other words, prices help coordinate economic activity. Changing these prices in such a way where they stop representing the "data of the market" will lead to discoordination. Consider the case of the subsidy, for example, where it creates profits where there shouldn't be. The best way to understand ABCT is by looking at its role in price formation.
Interest rates are probably less important than prices. The reason why the interest rate is emphasized is because it can signal changes in the supply of loanable funds -- of course, this isn't always true, it can also signal a fall in the demand for loanable funds. But, more important than the rate of interest is the volume of credit. Assume the Fed lowers the rates it can control, which impacts the margin at which banks can lend (allowing them to lend more). In a monopolized currency environment, where invidual banks' credit expansion can't be checked through an inter-bank clearing mechanism, this will lead to new credit equal to some multiplier of the original sum of credit lent (when the Fed lowered the Fed Funds rate, for example). This credit is lent and will be spent, and it will affect prices. In other words, it will affect profit and loss signals.
Assume that, at first, all new credit is lent to entrepreneurs looking to invest in the second-to-last stage of production, which are the firms that manufacture consumers' goods. An increase in investment implies an increase in demand for inputs (factors of production). The inputs for the second-to-last stage ae manufactured by the third-to-last stage. An increase in demand for inputs of this stage will increase profits there and will attract investment, which in turn will increase demand for fourth-to-last stage inputs. An increase in demand for factors of production will push up their prices, and a continued boom in these sectors will require more credit. But, in our economy there are only a finite amount of goods, some being consumers' goods and others being producers' goods. Let's say that before credit expansion there are 'x' economic goods, and that 'y' are producers' goods ('x-y' being consumers' goods). In order to fund a greater volume of investment you need more producers' goods, meaning less consumption. But, where credit expansion leads to new investment, not new savings, this transfer won't occur. Therefore, you have many new investments that can't come to fruition because there simply aren't enough producers' goods.
So, credit expansion not only affects goods that are relatively sensitive to changes in the interest rates, but also those goods which are now more profitable to manufacture. These new profits are called "phantom profits" (at least, by Hayek). When the source of phantom profits dries up (a slowing of credit expansion), all these investments will become unprofitable and we have a bust.
Even goods that are interest rate sensitive, I think, tend to be distorted more when prices are altered. Take housing, for example. What "sustained" the housing boom were continuously rising prices. Interest rates had a lot to do with it, but I think prices are more relevant. When did the boom end? When prices began to stagnate. A lot of credit expansion isn't signaled by changes in the rate of interest. Long-term mortgage rates fell, but even when this occurred a lot of credit expansion was sustained through shadow banking. Loan originators would sell their debt assets to investment banks and money managers, allowing the loan originators to sell more loans. Changes in the interest rate -- and new ways of packing interest [e.g. adjustable rate mortgages] -- were relevant in the sense that these changes made it more affordable for home buyers on the margin, but without advanced banking -- in an unstable banking system -- much of the boom we saw couldn't have happened (it would have been more limited). Investment banks, in turn, turned into deposit banks, because they would borrow from large firms overnight (e.g. repo), using their mortage debt assets as collateral. All of this credit expansion was only affordable as the price of housing rose. When prices began to stagnate, this whole system of credit expansion collapsed.
With regards to your last question, the Fed doesn't control interest rates. It can only control things like the Fed Funds rate. It can indirectly affect other interest rates, short-term rates being easier than long-term rates. The Fed is relevant, but even without the Fed these booms and bust would still occur (as they did before the Fed was founded in 1913). What would make booms and busts less prevalent would be a competitive banking system, where credit expansion would be checked because banks would be more immediately liable to make good on their banknotes -- notes where there's some uncertainty will trade below par, and customers will opt for safer currency.