Negative Interest Rate
Normally, banks may earn interest on certain funds they keep with the Central Bank. However, under a Negative Interest Rate Policy, it is the reverse. The Central Bank charges banks for keeping certain excess funds with it. This encourages banks to lend the money instead of keeping it idle. More lending is expected to encourage people and businesses to borrow, spend and invest, thereby increasing demand in the economy.
Negative Interest Rate Policy has been used by countries such as Switzerland, Sweden, Denmark and Japan.
Negative Interest Rate → Keeping Excess Money with Central Bank becomes Costly → Banks encouraged to Lend → Borrowing and Spending ↑ → Demand ↑
When Can Negative Interest Rate Policy Be Used?
Negative Interest Rate Policy is generally used when:
- The economy is experiencing a severe slowdown or recession.
- Inflation is very low or there is a risk of deflation.
- Conventional interest rates have already been reduced to zero or very low levels, leaving limited scope for further normal rate cuts.
- Borrowing, investment and aggregate demand remain weak despite very low interest rates.
In such situations, the Central Bank may push certain policy rates below zero to provide additional monetary stimulus.
Benefits of Negative Interest Rate Policy
- Encourages Bank Lending: Charging banks for keeping excess funds with the Central Bank encourages them to lend more.
- Encourages Borrowing: Lower interest rates reduce the cost of borrowing for households and businesses.
- Promotes Consumption and Investment: Increased availability of cheaper credit encourages people to spend and businesses to invest.
- Increases Aggregate Demand: Higher consumption and investment increase overall demand in the economy.
- Helps Counter Deflation: An increase in aggregate demand helps prevent a persistent fall in the general price level.
Downsides of Negative Interest Rates
- Changes Saving and Borrowing Behaviour: Negative interest rates alter the way normal investment and savings behaviour function because now a saver is paying for parting with cash and a borrower is being perversely incentivised to borrow more.
- Risk of Excessive Government Borrowing: Governments can borrow at very low costs under negative interest rates. This may encourage excessive borrowing. If the government is unable to repay its debt, it can damage its credibility and have serious consequences for the wider economy.
- Pressure on Bank Profitability: Financial viability of banks comes under strain if the loans they extend lose money by design. This forces banks to also raise charges on other services, making them more costly than they need to be – in turn, hurting consumer demand.
- Encourages Cash Holding: If depositors are charged negative rates, they may prefer to hold physical cash rather than keep money in banks, limiting the effectiveness of the policy.
