Is it done by majority vote or does one instance have more control than others cough cough lemmy world cough if so then this is not really federated is it and with each instance we now have basically upgraded mod power to admin power so one more question is each instance independently monetized?
Others have answered quite well but here is some info I think they have missed.
You can see what instances are federated/federated here: https://lemmy.world/instances (for lemmy.world) change the front to your instance to see who they allow/block. (Federated at the top, de-federated at the bottom in a different section.
When your instance defederates another instance, it won’t show communities from that instance. Users of the blocked instance can still see your instances content.
(I don’t actually know what happens to comments from the blocked instance on posts in neutral communities)