In the previous lesson, you learned that central banks create physical money, but that role goes hand in hand with another important task: keeping the value of money as stable as possible. When money declines in value, this is called inflation. You hear talk of inflation when products and services become more expensive, meaning you can buy less with the same amount of money. In the next module, you’ll learn more about how inflation impacts the cost of living.

Aiming for under 2%

Central banks use their policies to manage inflation, aiming to keep it under control rather than eliminate it entirely. Having no inflation at all can also create problems for the economy.

Too much inflation

When inflation is too high, saving becomes less attractive. After all, what use is it putting money aside for later if it just keeps losing value? 

The consequence of high inflation is that more money circulates in the economy, as less is saved.

The disadvantage of high inflation is that prices rise quickly and become unpredictable. As a result, businesses tend to become more cautious about investing, which can negatively affect economic growth.

In addition, wages don’t often increase as quickly as inflation, since most people only receive a pay rise once a year. High inflation means that, in the short term, people can buy less with their current salary. Their purchasing power declines.

This creates uncertainty about the future, which is also bad for economic growth.

Too little inflation

On the other hand, inflation that is too low is also undesirable. Deflation in particular — when money becomes more valuable instead of less — can harm the economy. Consumers tend to save more and delay purchases. As a result, a lot of money remains ‘locked away’ in savings accounts and too little circulates in the economy, having a negative impact on economic growth.

2% — just right?

Through their monetary policy, central banks therefore try to get inflation ‘just right’: not too high and not too low. This helps keep the value of money reasonably stable while the economy continues to grow. An inflation rate of around 2% is generally considered desirable.

Adjusting interest rates

So how do central banks influence inflation? They do this by adjusting the key interest rates. Interest is the price you pay for borrowing money.

If inflation is too high, a central bank can raise interest rates. Here’s how that works:

1. Commercial banks regularly borrow money from the central bank. The central bank charges interest on these loans.

2. When interest rates rise, it becomes more expensive for commercial banks to borrow money.

3. Banks pass these higher costs on to businesses and consumers, making borrowing more expensive for them as well.

4. As a result, less people apply for mortgages and other loans.

5. Overall demand in the economy falls, and inflation slows down.

If inflation is too low, the opposite happens and the central bank may lower interest rates.

Takeaways

• Central banks aim to keep the value of money as stable as possible.

• Central banks try to control inflation, ideally keeping it positive, but under 2%.

• Their main tool to do this is interest rates, which they adjust up or down.