Central Bank: What It Does, How It Sets Rates, and How Money Gets Made

Whoever sets the cost of a mortgage or a loan isn’t the bank teller behind the counter, it’s a decision made further upstream, at the central bank. The monetary system rests on two different players that constantly interact: commercial banks, the ones an account holder deals with every day, and the central bank, which sits a level above and shapes the conditions they operate under. It’s a topic that belongs to microeconomics and macroeconomics: it involves choices made by individual banks, but with effects across the whole economy.

Commercial banks, between savings and credit

In Italy, the Consolidated Banking Act of 1993 defines banking activity as the joint exercise of two functions: taking in savings from the public and granting credit. Neither works without the other: a bank that only took in deposits without lending them out, or that only lent without a source of funds, wouldn’t be doing banking in the proper sense.

To raise funds, banks don’t rely on deposits alone: they also issue bonds, promises to repay the sums received on a set date and with a given return. Of these funds, part stays in reserve to meet customers’ cash withdrawals; the rest funds loans and purchases of securities. Banks also exchange liquidity with each other, on the interbank market, when one needs to cover a cash shortfall and another has funds to spare.

Legal tender and bank money

Not all money is created the same way. Legal tender, the kind that settles monetary obligations by law, is issued only by a central bank: for the euro, the European Central Bank. Its creation follows strict procedures, designed to keep its value stable over time.

Most everyday payments, from card swipes to bank transfers, run on bank money, not physical banknotes: according to the ECB, this form of money makes up the part of the money supply people actually use most in daily life, even though it coexists with legal tender. In Italy, the authority that keeps an eye on this balance is the Bank of Italy, which supervises the operators authorized to issue bank money.

What a central bank does

Monetary policy, the Bank of Italy explains, covers the decisions a central bank makes to influence the cost and availability of money in the economy. In the euro area, the most closely watched decision is usually the one on reference interest rates: when the ECB changes them, the decision in turn affects the rates commercial banks charge their customers on loans. The Bank of Italy takes part in these decisions through its Governor, who sits on the ECB’s Governing Council.

In periods when inflation stays low for a long stretch and rates are already low, the central bank can also turn to less conventional tools, such as asset purchase programs, to keep influencing credit conditions once the interest-rate lever has already given what it could.

The 2% target, since 2021

On 8 July 2021 the ECB’s Governing Council approved a new monetary policy strategy: the goal is to keep inflation at 2% over the medium term, in symmetric form, meaning deviations above and below target are treated as equally undesirable. Before that date, the target was worded differently; symmetry is a feature of the strategy adopted in 2021, not a rule that always existed. This goal, the Bank of Italy explains, also helps support the European Union’s broader economic policies aimed at full employment and growth.

How money is created when a bank grants a loan

Here comes the part that surprises most newcomers to the topic. According to the ECB’s explainer, when a commercial bank grants a loan, say, to buy a car, it creates money at that moment; when the loan is repaid, the money created disappears. The commercial bank creates that money the moment it grants the loan. The central bank remains the only source of legal tender, but much of the bank money used every day comes from credit granted by commercial banks in exactly this way.

Practical example: a family asks their bank for a mortgage to buy a home. The moment the bank approves the loan, it credits the amount to the family’s account: that sum is newly created money, not money withdrawn from someone else’s deposit. As the family repays the installments, that money is gradually cancelled out.

The same distinction between legal tender and bank money also underpins more recent innovations, such as the digital euro, designed precisely as a form of central bank money accessible directly to the public. This mechanism isn’t unchecked: according to the Bank of England, regulation limits how much money banks can create, and banks must hold their own capital resources against the risk of borrowers defaulting, constraints that have tightened since the financial crisis.