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What is the key interest rate?

The key interest rate is the central banks' most important monetary policy instrument. The key interest rate is the interest rate at which commercial banks can borrow money from the central banks, i.e. refinance themselves. Through the level of the key interest rate, the central banks have a direct influence on the money supply within a currency area. Within the euro zone, for example, the European Central Bank (ECB) is responsible for setting the key interest rate.

What is the function of the key interest rate?

With the key interest rate, a central bank determines the price that commercial banks have to pay for refinancing themselves. A change in the key interest rate by the central bank up or down always has a far-reaching signal effect on monetary policy. The central bank can use the key interest rate to control the money supply in circulation and thus indirectly also inflation or deflation. If, for example, the inflation rate in a currency area is particularly low, deflation threatens. Consequently, the central bank will counteract this and promote inflation. It will do this by successively lowering the interest rate, thereby giving banks the opportunity to borrow cheap money. This money is in turn passed on by the bank to companies in the form of cheap loans. Thanks to these loans, companies can make investments, hire new employees and increase demand. This causes prices to rise and inflation to increase. This mechanism can also be reversed. In this case, the central bank gradually increases interest rates to stop the flow of money.

What influence does the base rate have on the investment of money?

The key interest rate also has an indirect influence on the attractiveness of investments for private investors. If the key interest rates are high, banks can invest money with the central bank on good terms. As a result, the interest rates for private investments are also correspondingly high - from which investors benefit. Conversely, investments with banks are unattractive in low-interest phases, so that other forms of investment such as shares, real estate and tangible assets become more desirable.

How does the key interest rate influence a currency?

Key interest rates are used as a means of monetary policy control. If the interest rate changes, this has a strong influence on the external value of the currency, as its exchange rate also changes. This in turn has consequences for the relationship between exports and imports, as exports become more expensive and imports cheaper. The key interest rate can therefore be used to also reflect expectations regarding exchange rate and inflation developments.

Who sets the European base rate?

The decision to change the European key interest rate is in the hands of the central bank. In the European area, the European Central Bank (ECB), and thus the Governing Council of the ECB, is responsible for this. At the German Bundesbank, it was the Central Bank Council. As the Bundesbank had been only an executive body of the ECB since January 1999, the Central Bank Council was relieved of its responsibility for setting the key interest rate. In April 2002, it was therefore completely abolished as an organ. The Governing Council of the ECB decides on the timing, extent and direction - increase or decrease - of the key interest rates.

What does a negative key interest rate mean?

During the 2008 economic crisis, the European Central Bank and the US Federal Reserve (FED) cut their key interest rates to a record low. The possibility of a negative key interest rate was hotly debated because the interest rates of the ECB and the FED had already been cut to just over zero percent at that time. If a central bank introduces a negative key interest rate, commercial banks will have to pay money for their investments with this bank. The central bank thus practically charges a fee for other credit institutions to invest money with it. At the same time, commercial banks are given money as a gift when they take out a loan with the central bank. So far, however, only Switzerland and Sweden have made use of this possibility, as negative key interest rates are highly controversial among economists.