What is a Negative Interest Rate?

A negative interest rate policy of banks, including central banks and private banks, works in the economy so that the overall demand of the elements of the economy like households, industrialists, capitalists, etc., increases for products in the market.

So basically, by making the interest rate below zero, the cost of investing rises, and borrowing costs reduce. It increases consumer spending, and hence, the demand for the products and services rises, despite 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.

Example

Following countries are currently allowing the banks to charge a negative interest rate in their economy:

  • Denmark’s government is 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.

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How Does Negative Interest Rate Work?

As mentioned earlier, It is one of the last resorts to boost the economy where other conventional ways prove to be insufficient in this situation. Basically, in deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more, there is minimal pressure on banks to offer deposits. Thus, by lowering the interest burden and then making it negative, the cost of borrowing of the households and companies reduces, increasing the demand for loans and increasing 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. It is how the whole situation works.

Risks

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 increase their spending. It was the cycle of growth in the economy of the country that broke.It affects those industries, lenders, and institutions that are solely based on lending the money and not accepting the same since now they have to pay interest and lend money.For banks, to raise the income from the storage of cash of the investors, the banks’ risk 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 a capital buffer since the bank faces problems over cash deposits by attracting more investments and increasing the investors’ confidence.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?

  • A negative interest rate policy is like taking a loan from the bank, and the borrower gets paid for the loan. Thus, under this policy, the bondholder pays the interest to the bond’s issuer; thus, the situation is exactly opposite from the normal economic cycle.Thus, we can make money from this situation by accepting deposits, borrowing funds, and offering bonds and other financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more. Also, banks and other money lenders and money traders can reverse the gap between money lending and money borrowing or holding cash deposits and earn the difference in the interest rate.Thus, they offer more loans and accept fewer deposits to earn the interest gap. 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 periods of deflation, bringing the economy to a normal level is very important. 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 and 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 customers’ rates and encouraging banks to provide further cash deposits..

Conclusion

Thus in the situation of deflationary pressures in the economy, the government can provide the policy of charging these rates, 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 the negative interest rate and its meaning. Here we discuss how the negative interest rate works along with its risks, reason, and example. You can learn more about finance from the following articles –

  • Economic UtilityInterest Rate Risk TypesNominal Interest Rate CalculationInflation vs Interest Rate