Definition
A Negative Interest Rate refers to a monetary policy tool where the central bank or monetary authority charges commercial banks for holding deposits in an attempt to encourage more lending. In essence, it flips the traditional interest concept, as depositors must pay to deposit their money, and borrowers are credited for borrowing money. It is normally implemented to stimulate economic growth during deflationary periods.
Key Takeaways
- Negative Interest Rate refers to an unconventional monetary policy tool where central banks set nominal target interest rates below zero. It’s primarily used to encourage economic activity by discouraging banks and individuals from holding onto money instead of spending or investing it.
- It results in a situation where depositors have to pay to keep their money in a bank, rather than earning interest on it. Conversely, it can mean that borrowers may get paid to borrow money, which helps to stimulate investment and spending in the economy.
- Finally, negative interest rates can have complications and potential risks, like stimulating risky investments, causing a gradual breakdown of the financial structure, and contributing to cash hoarding if investors decide to pull their money out of banks to avoid the negative rates.
Importance
Negative Interest Rate is a significant finance term as it comprises an unconventional monetary policy tool implemented by central banks to stimulate economic activity. This policy is typically used when traditional methods, such as a decrease in standard interest rates, prove to be ineffective.
Economies with negative interest rates essentially charge financial institutions for holding excess reserve balances, motivating these institutions to lend more, thus increasing the overall money supply. It also encourages consumers and businesses to spend and invest money rather than hoarding it, thereby invigorating economic growth.
However, it may also lead to financial market distortions and risky economic behavior. Hence, understanding the implications of negative interest rates is crucial for both policymakers and market participants.
Explanation
Negative interest rate is a monetary policy tool used principally by central banks to stimulate economic activities, especially during periods of economic downturns or financial crises. The main purpose of negative interest rates is to incentivize borrowing among businesses and consumers and disincentivize saving. When interest rates are negative, it essentially means that instead of earning money on savings, depositors have to pay to keep their money with the bank.
This offers an impetus for people and businesses to spend and invest money rather than stockpiling it, thereby fueling economic growth. At the same time, negative interest rates have implications for financial institutions. Banks are basically being charged for keeping their surplus cash reserves deposited with the central bank.
The goal here is to encourage banks to lend this money to businesses and consumers instead of holding onto it. By boosting loan activity, it helps to increase spending and investment in the economy, stimulating economic growth and combatting deflationary pressures. Please note that negative interest rate is typically used as a last resort strategy when conventional monetary policy tools fall short.
Examples of Negative Interest Rate
European Central Bank’s Negative Interest Rate Policy: The European Central Bank (ECB) introduced negative interest rates in June 2014, lowering its deposit rate to -1%. The intention was to encourage banks to lend more money, rather than holding onto it, to stimulate economic growth. This move effectively means that banks have to pay the ECB to hold their money overnight.
Japan’s Central Bank Negative Interest Rate: The Bank of Japan (BOJ) introduced negative interest rates in January 2016 for the first time, with it being set at -1%. This measure was meant to overcome deflation and stimulate economic growth. However, some of the side effects were that banks’ profitability decreased due to the difficulty to pass on negative interest cost to their customers.
Swiss National Bank’s Negative Interest Rate: The Swiss National Bank (SNB) introduced negative interest rates in January 2015 to help lower the value of the Swiss franc, which had been increasing due to investors viewing it as a “safe haven” currency. The interest rate was initially set at -75%.All these examples reflect central bank’s efforts to influence their economies positively however, the long-term effects of negative interest rate policies still remain unclear.
Frequently Asked Questions about Negative Interest Rate
What is a Negative Interest Rate?
A negative interest rate is an unconventional economic concept where depositors pay to keep their money with the bank, instead of earning interest. It is generally implemented during severe economic downturns to encourage spending and borrowing, and discourage people from hoarding cash.
How Does a Negative Interest Rate Work?
In negative interest rate policy, the central bank sets interest rates below zero. For example, if the rate is -1%, you won’t get interest on your deposit. Instead, you’ll have to pay to keep your money in the bank. So, if you deposit $100, at the end of the year you would have $99 in your bank account.
What are the Effects of Negative Interest Rates?
Negative interest rates aim to incentivize banks to lend more, thus stimulating investment and consumption. On the downside, they can hurt the profitability of banks as it narrows the margin between lending and deposit rates, and may lead people to keep cash at home rather than in banks.
Where are Negative Interest Rates Applied?
Negative interest rates have been used by central banks in Europe and Japan as a policy tool to combat deflation and boost economic growth. However, it’s a relatively new and controversial strategy which effectiveness and consequences are still being fully understood.
Do Negative Interest Rates affect Mortgages and Loans?
Essentially, negative interest rates can lead to cheaper loans, including mortgages. This is because banks are incentivized to loan money. However, the exact impact on individual consumers can vary, depending on the terms of their loans and the overall health of the economy.
Related Entrepreneurship Terms
- Central Bank
- Quantitative Easing
- Monetary Policy
- Inflation
- Deflation
Sources for More Information
- Reuters: Reuters provides business, financial, national and international news to professionals via desktop terminals, the world’s media organizations, industry events and directly to consumers.
- Bloomberg: Bloomberg delivers business and markets news, data, analysis, and video to the world, featuring stories from Business Week and Bloomberg News.
- Investopedia: Investopedia is the world’s leading source of financial content on the web, ranging from market news to retirement strategies, investing education to insights from advisors.
- The Economist: The Economist offers authoritative insight and opinion on international news, politics, business, finance, science, technology and the connections between them.
