Central banks sit at the center of modern economies. They make decisions that influence the most critical aspects, including interest rates, inflation, borrowing costs, currency values, and overall financial stability. Yet for most of us, these institutions feel distant, government bodies that operate far from daily life. In reality, the policies they set directly affect wages, housing market, employment rates, and the cost of a basic basket of products and services. When these effects are unevenly distributed, central bank interventions can widen or narrow economic inequality.
What central banks actually do
Understanding what central banks do and how these actions affect every aspect of economic equality is crucial. The most influential central banks are the Federal Reserve of the US and the European Central Bank (ECB). Put simply, what are the ECB and similar central banks if not powerful economic engines capable of shaping and directly impacting the distribution of wealth worldwide? Despite complex reputations, central banks share a core mission everywhere: maintain price stability and support overall economic health. Their main functions include setting interest rates, managing inflation, regulating banks, maintaining stability, and more. This one core mission of price stability is behind all the interventions done by central banks. Let’s briefly discuss each of these.
Setting interest rates
The interest rate set by central banks influences all borrowing costs across the economy, including mortgages, business loans, credit cards, and government debt. Higher rates slow down the economy as all loans become expensive and both people and businesses avoid bank loans, meaning less money flows into the economy. A lower rate, on the other hand, boosts the economy and makes it easier and cheaper to borrow money for anything.
Managing inflation
Inflation affects purchasing power and ultimately everything in the economy. Central banks aim for moderate inflation, and they usually have a target that is mostly around 2%, depending on the country. This prevents economic overheating and deflation. It is argued by many economists that moderate inflation is positive for the economy.
Regulating banks
Central banks supervise financial institutions, act as lenders of last resort, and step in during crises to prevent widespread failures. In other words, central banks are banks for the commercial banks, lending them money and taking deposits.
How can central bank monetary policy widen inequality
Central banks do not aim to redistribute wealth, but their actions and interventions have distributional effects. When certain households or regions benefit more from these changes than others, inequality grows.
Low interest rates boost asset owners
When central banks cut interest rates, stocks rise, property prices climb, and bonds become more valuable. Stocks rise as companies can take loans more cheaply, they can allocate capital cheaply and expand their business, while retailers and investors also have cheaper loans to invest in rising stocks, strengthening the bullish momentum even more.
Households that already own assets gain wealth while those without access to real estate or investments fall behind, widening the inequality gap. This asset inflation is a repeating pattern across Europe, the USA, and emerging markets over the past decade. What this indicates is that if you know how central banks influence markets and the economy, you can anticipate certain patterns and avoid getting caught on the losing side.
High interest rates hit borrowers the hardest
If lower rates make life easier for companies and retailers who can borrow cheaply, higher interest rates create an opposite effect. It becomes more expensive to take a loan and to invest money, meaning the economy starts to slow down, and stock markets usually retreat. However, borrowers are among the ones hit the hardest because their loans become even more expensive, making it difficult to pay them back. When rates rise:
- Mortgage payments rise
- Credit costs increase
- Small businesses struggle to borrow
- Job creation slows
Lower and middle-income households that rely more on credit suffer first. This is why the Fed in the USA lowers rates whenever it can to boost the economy.
Inflation is uneven
Inflation does not hit everyone equally. Essentials such as food, fuel, rent, and utilities often rise much faster than luxury goods. As a result, lower-income families, which spend a larger share of these necessities, face disproportionately higher pressure during inflationary periods. They might feel that their income no longer holds the same purchasing power as before. If inflation rises while wages lag, which is usually the case, living standards diverge more sharply.
How central banks can reduce inequality
Central banks also have the tools necessary to support stability, protect vulnerable groups, and indirectly soften inequality. The first and most effective tool for central banks is to maintain price stability by controlling inflation to preserve purchasing power. This is critical for wage earners, pensioners, and low-income households with little to no savings. When central banks lower rates during a crisis, they help prevent mass layoffs, and employment is the most powerful equalizer in modern economies. The ECB, Fed, and other reputable central banks increasingly analyze distributional impacts and promote complementary policies such as minimum wage frameworks, housing market reforms, financial initiatives, and access to credit for small businesses. These tools might seem small, but in conjunction, they can soften the gap between the rich and the poor and ensure stable economies.