03/28/2008 02:46 am ET | Updated May 25, 2011

How The Fed Influences Your Life

With the economy teetering on recession, the nation's central bank recently took the unprecedented step of lowering interest rates twice in three weeks. How does the Fed influence interest rates, the economy--and your life?

What exactly does the Fed do?
It operates like a big dam, regulating the flow of money into the economy. The Fed's goal is to prevent both "droughts''--recessions--and "floods''--inflation. Congress created the Federal Reserve System in 1913, after a string of bank collapses battered the economy and stripped millions of people of their life savings. Today the Fed--a network of 12 government banks spread across the country--is responsible for keeping prices stable and long-term interest rates moderate. That may sound arcane, but the Fed's machinations affect everything from the price of home loans to whether the economy is adding jobs or losing them. When the Fed manages the economy well, said former Fed official Robert McTeer, "fewer people go to prison, more are healthier because they can afford to take better care of themselves, even the environment gets better taken care of."

How does the Fed have such a huge impact?
It all stems from its ability to manipulate how much money is available to businesses and individuals seeking loans. When the Fed wants to lower rates, it buys billions of dollars worth of government-backed bonds, thereby pumping money into the banking system. The increased availability of money reduces its cost--that is, the rate of interest. To raise rates, the Fed sells securities, which drains money from the system. By tinkering with rates, the Fed can tighten or loosen the amount of money coursing through the economy. Last August, when bond and stock markets were on the brink of a meltdown, the Fed cut the Fed funds rate by a quarter-point, which pumped $38 billion into the banking system. That reassured investors, who sent the stock indexes soaring, which calmed consumer jitters--at least for a while. "The Fed's control over the money supply," said Gregory Mankiw, a former economic advisor to President Bush, "is a powerful lever to move overall demand for goods and services."

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