Its mainly applicable to the US but the same principle applies in most countries.
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Interest rates are one of the Fed's most powerful tools for implementing monetary policy. The Fed sets several key interest rates that influence borrowing and lending across the economic spectrum. The first is the federal funds rate, which is the interest rate that one bank charges to another for borrowing cash reserves. It's calculated according to basic laws of supply and demand. The more money banks have in reserves, the lower the rate. The more demand for loans, the higher the rate.
The interesting part is that the Fed controls the supply and demand. If the Fed wants to lower the funds rate, it buys securities from banks, injecting more cash into their reserves. If the Fed wants to raise the funds rate, it sells government securities back to the banks, lowering their cash reserves. This tinkering with supply and demand is called open market operations, another tool of monetary policy.
The interesting part is that the Fed controls the supply and demand. If the Fed wants to lower the funds rate, it buys securities from banks, injecting more cash into their reserves. If the Fed wants to raise the funds rate, it sells government securities back to the banks, lowering their cash reserves. This tinkering with supply and demand is called open market operations, another tool of monetary policy.
http://money.howstuffworks.com/interest-rate.htm
