Central Banks and Interest Rates

Central banks issue a country's currency and manage its supply, mainly by setting short-term interest rates. Raising rates makes borrowing more expensive, cooling spending and inflation; cutting them encourages borrowing and investment. Sweden's Riksbank, founded in 1668, and the Bank of England, founded in 1694, are among the oldest; the US Federal Reserve dates from 1913 and the European Central Bank from 1998.

Many economists argue that central banks should be independent of elected governments, because politicians may be tempted to stimulate the economy before elections at the cost of later inflation. Paul Volcker's Federal Reserve showed the power of interest rates when it raised them to around 20 percent in 1980–81, crushing high inflation at the cost of a deep recession. Because capital flows across borders, decisions by major central banks, especially the Fed, affect exchange rates, borrowing costs and capital flows worldwide.