http://www.voanews.com/english/2008-02-27-voa64.cfm

I never knew much about the federal interest rate until I took Econ 102 my sophomore year. My professor would often talk of Alan Greenspan, the chairman of the Board of Governors of the Federal Reserve at the time, meeting to discuss changing the federal interest rate. I believe at the time, the general trend of the interest rate was increasing, and before we talked about its impact on the economy, all that meant to me was that when I received my monthly interest on the my savings account, it would be a little bit bigger.

Recently, however, the Federal Reserve has been cutting the federal interest rate in order to boost the economy. The reason this works is because with the lower interest rate, businesses are more likely to take out loans and spend money which in theory helps to boost the economy. Lower interest rates also encourage spending in general since savings accounts now will be earning less money through interest. The Federal Reserve decreases the interest rates when businesses are struggling, stocks are falling, and in times of recession.

Really, the whole situation can be viewed through game theory as a two-move sequential move game. The two players are the government/economy and the businesses. The goal of the government is to boost the economy and the goal of the businesses is to make more money - both players know each other’s objectives. The government moves first and lowers the interest rate. They do this because they know the best response for the businesses is to take out loans and spend money, putting it back into the economy. As predicted, the businesses do so. In this game the government has achieved its goal of getting businesses to invest in the economy and at the same time the businesses also come out ahead because they have more money (from loans) to spend. Having more money helps them to increase business through advertisement, buying new equipment, and other means.  In this game, both players are essentially winners in the long run.