What is a Negative Interest Rate?
Negative interest rate is when the banks charge interest from customers for storing cash with the bank and the prime reason for such a charge is that, at times of deflation, people generally prefer to retire money instead of spending it or investing the same.
A negative interest rate policy of banks including central banks and private banks works in the economy in such a way that the overall demand of the elements of the economy like households, industrialists, capitalists, etc. increases for products in the market.
So basically, with making the interest rate below zero, the cost of investing rises and borrowing cost reduces. This increases consumer spending and hence, the demand for the products and services rises, in spite of the increase in the prices of goods and services in the economy. These further have two effects, the producers and suppliers are encouraged to manufacture and supply and, the bankers are incentivized to create more deposits.
Following countries are currently allowing the banks to charge a negative interest rate in their economy:
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- Denmark’s government charging the negative interest rate of approx. -0.7%
- European govt. allows the banks to charge the negative interest rate of approx. -0.4%
- Also, Switzerland, Japan, Denmark are included in those countries.
How Does Negative Interest Rate Work?
As mentioned earlier, It is one of the last resorts to boost the economy applied where other conventional ways prove to be insufficient in this situation. Basically in the situation of deflation, there is minimal pressure on banks to offer deposits. Thus by lowering the interest burden and then make it negative, the cost of borrowing of the households and companies reduces which increases the demand for loans as well as increases household spending.
They further prevent passion for the reduced costs of the cash deposits to small lenders and depositors and hoarding the cash and earning the income on such deposits. This is how the whole situation works.
Following are major risks of this rate policy in the economy:
- Firstly, with an increase in investment costs, it is not always so that the people are encouraged to borrow money and to increase their spending. This was the cycle of growth in the economy of the country breaks.
- It affects those industries, lenders, and institutions which hard solely based on lending the money and not accepting the same since now they have to pay interest as well as lend money.
- For banks, in order to raise the income from the storage of cash of the investors, the risk of the banks also increases with regards to the assets of the banks and further results in an asset bubble.
- It becomes difficult for the banks to create capital buffer since by attracting more investments and increasing the investors’ confidence, the bank faces problems over cash deposits.
- Enterprises working in developing countries face problems of over-lending as per the specific regulations of the law.
How to Make Money from Negative Interest Rate?
- The policy of a negative interest rate is like taking a loan from the bank and the borrower gets paid for the loan. Thus under this policy, the holder of the bond itself pays the interest to the issuer of the bond, hence thus the situation is exactly opposite from the normal economic cycle.
- Thus by accepting deposits, borrowing funds and offering bonds and other financial instruments, we can actually make money from this situation. Also, banks and other money lenders and money traders can actually reverse the gap between money lending and money borrowing or holding cash deposits and earn the difference in the interest rate.
- Thus befits, they offer more loans and accept less deposit to earn the interest gap, now they need to reverse the gap and continue to make money from the differential interest.
Impact of Negative Interest Rate on Economy
Presently Europe has a policy of negative interest rate, however, there is no such policy in the United States of America. An economy is affected in the following ways due to this –
- During the periods of deflation, bringing the economy to the normal level is very important and hence simply cutting the interest rates to Nil is never enough to encourage borrowing and lending, and hence in such a situation, these rates are very advantageous.
- It stops the fall in the demand level as well as a stoppage in the production of outputs by the manufacturers and industrialists due to a reduction in price levels during deflationary pressures.
- Employment opportunities increase by charging these rates from customers and by encouraging banks to provide further cash deposits.
Thus in the situation of deflationary pressures in the economy, the government can provide the policy of charging these rates and thus helping the economy to maintain the demand-supply level and to grow in the situation of deflation, Further providing an incentive to banks as well as the producers and suppliers to continue to provide deposits or produce the output to run the economy.
This has been a guide to what is the negative interest rate and its meaning. Here we discuss how does negative interest rate works along with its risks, reason, and example. You can more about finance from the following articles –