Interest rate amounts to the cost that one pays for borrowing money. For instance, an annualized 10% interest rate, on a $1,000 loan, would require a borrower to repay the loan in full as well as an additional $100 as interest.
However, when it comes to a negative interest rate, the lender simply pays the borrower for borrowing money. Conversely, an annualized -2% interest rate on a $50 loan would see the lender paying the borrower $1 after one year.
That said, negative interest rates are financial tools used by policymakers to fuel borrowing in an economy. Whenever policymakers run out of policies to stimulate spending in an economy, they normally turn to negative interest rates.
Understanding Negative Interest Rates
Negative interest rates are common with economies struggling with high inflation levels that cause the value of a currency to plummet, consequently making goods and services expensive. High inflation levels result in a decrease in demand for products, as very few people can afford them.
Faced with subdued levels of spending, central banks introduce negative interest rates as a way of encouraging people to borrow. By encouraging people to borrow, central banks hope to get more money into the economy that would consequently fuel spending patterns.
A push into negative interest rates comes into play whenever conventional monetary policies fail to have the desired impact in fuelling spending patterns. The European Central Bank was the first to introduce negative interest rates in 2014, consequently followed by the Bank of Japan. The two cut the benchmark below zero in a bid to stimulate the economies and overcome deflationary pressures.
Negative Interest Rates Pros
A key benefit of negative interest rates is that they lower borrowing costs, making it possible for people to borrow to revitalize spending. Similarly, negative interest rates weaken a country’s currency. A weakened currency would make a country’s export to be competitive, a move that most of the time, boosts inflation by pushing import costs up.
Conversely, negative interest rates also come with a fair amount of challenges. For starters, they narrow the margin that financial institutions earn on lending money to people. Prolonged interest rates can also hurt the financial health of financial institutions, a move that could force most of them to stop lending, consequently damaging the economy even further.
In addition, there are limits as to how far central banks can go with negative interest rates to stimulate the economy. Likewise, financial institutions can avoid being charged negative interest rates by opting to deposit actual banknotes.