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What is a central bank?

Zentralbank
What is a central bank?
The 20 member states of the European Union that introduced the euro as their official currency form a common currency area, the euro area (sometimes also called the eurozone or euroland). Its supreme monetary policy institution is the European Central Bank (ECB), which was founded in 1998 and has its seat in Frankfurt am Main, Germany. The ECB is the only bank that has the right to determine how much euro money is in circulation in the euro area. It controls the money supply, making sure that not too many euros are issued. This protects the value of the euro – if there were too much money in circulation, that value would drop. As guardian of the stability of the euro, the European Central Bank ensures that prices neither rise nor fall too much.

Inflation

Inflation means that prices rise, so that people have to pay more for the same products than last year. The euro area usually registers some inflation, and the ECB aims at an inflation rate of up to two per cent, which stimulates the economy. However, price increases of more than two per cent may have negative effects. If prices soar within a short time, money loses its value very fast, and the same amount of currency will buy less and less. Such a scenario can pose a big threat to the economy.

Deflation

A trend towards deflation also harbours risks. In a deflationary scenario, prices fall, and the value of money rises. This may sound great because people have to spend less money for the same goods – but deflation causes businesses to invest less, as they do not expect to profit from investing. Moreover, individuals may postpone spending as they wait for prices to go down further, and they have to pay more for loans and other forms of credit.

Price stability

The European Central Bank does not have the power to determine prices, but what it can do is set the interest rates at which it lends money to other banks. If these key interest rates are low, people can obtain credit more easily – with the risk that they may start living beyond their means. Low interest rates stimulate the economy, but there is also a danger of “overheating”. If interest rates are too high, fewer loans are granted, and the lack of credit thwarts economic growth. The ECB’s mission is to ensure a good balance between money supply and available products.
What is a central bank?

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