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A central bank is the institution responsible for the monetary and interest rate policy of a country or region. It determines the official interest rate and safeguards the stability of the financial system. A central bank operates above regular commercial banks.
The central bank influences how much money is available in the economy.
By raising or lowering interest rates, a central bank steers the economy. A higher interest rate makes borrowing more expensive and slows down spending. A lower interest rate makes borrowing cheaper and stimulates investment and consumption.
In the euro area, this policy is determined by the European Central Bank. Central banks aim to keep inflation stable and prevent financial crises. Their decisions directly affect savings rates, mortgages, bonds and stock markets.
Short example:
Suppose inflation rises to 5% per year. The central bank decides to increase the interest rate from 2% to 4%. As a result, banks must pay more interest to borrow money from the central bank. They then raise their mortgage rates and lending rates for consumers. Borrowing becomes more expensive, people spend less and the economy cools down. This can gradually reduce inflation.
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