What It Is:

The Federal Reserve System, or the Fed, is responsible for managing the country’s banks, and by extension, how Americans can spend their money.

The Fed consists of two major components.

1. Regional Federal Reserve Banks: There are 12 such banks around the country. Each manages their respective local banks. In addition, as the name would suggest, these 12 banks hold the reserves for state and national banks.
2. The Board of Governors: Seven president-appointed and Senate-confirmed members make up the board and hold 14-year terms. Ben Bernanke chairs the Board, which mandates Fed policy. Most notably, it sets the Federal Funds Rate – the interest rate that banks charge each other for loans.

How It Works:

According to the 1913 bill that created the Fed, it must, "Promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

The Fed manages monetary policy via three distinct avenues.

1. Reserve Requirement: This stipulates that all banks must hold in reserve a certain percentage of their deposits. This number is usually around 10 percent. Because customers continually affect a bank’s reserves, banks are forced to borrow from other banks to meet the reserve requirement.
2. Regulation of the Federal Funds Rate: This rate is actually a target number, set by the FOMC, suggesting the interest banks should pay each other for loans. While banks rarely meet the exact rate, they follow the suggestions of the FOMC quite closely.
3. Discount Rate: Unlike the Federal Funds Rate, the Fed fixes this rate. The discount rate regulates the interest banks must pay to borrow from the Federal Reserve Bank. The Fed discourages lending from Reserve Banks because it drains Federal Reserve. However, the option is offered as a last resort for banks that cannot otherwise meet the Reserve Requirement.

Why It Works:

The driving force behind the Fed is the Federal Funds Rate. If this rate is low, banks can offer low-interest loans to its customers. Predictably, these low rates result in customers taking out more loans. The opposite is also true. When the Fed raises rates, banks, in turn must raise their loan rates, and customers borrow less.

At the most basic level, the Fed lowers rates when the economy is lagging -- a move that allows consumers to borrow, and thus spend more, fueling an economic upturn. On the other hand, when the Fed senses that inflation has set in, it raises rates, which stifles consumer activity.

However, the Fed cannot, and does not, simply declare that rates have changed. Instead, they control interest rates through buying and selling securities on the open market. When the Fed decides to buy securities, such as bonds, it must create reserves in order to pay for the purchase. This raises the total amount of capital in the Federal Reserve, thus lowering the rate the Fed, and in turn banks, charge to borrow money. Conversely, when the Fed sells securities, its reserves are depleted, thereby raising interest rates.

These rates directly affect the amount consumers can spend on long-term loans such as home mortgages and corporate bonds. When the Fed changes interest rates, it takes about six months for consumers to feel the full effect of the changes. Nonetheless, once the changes filter from the Fed to the Reserve Banks to local banks to the consumer, individuals and business alike must adjust to the new financial conditions.