Negative interest rates are an instrument of unconventional monetary policy applied by central banks in order to encourage commercial banks to start lending more to the private sector, they do it by making it costly for commercial banks to hold their excess reserves within the central bank.

With negative interest rates, borrowers earn an income in the form of interest rather than paying interest to lenders.

The idea that lenders ought to pay rather than earn from the money they lend may seem outrageous, but it should not be anymore, because in fact in many modern economies, not only the interest rate on excess reserves of commercial banks, but also government debt yielding negative interest rates is becoming widespread.

As highlighted by Deloitte in the “Monetary policy in advanced economies” report, by the end of Agust 2019, more than US$17 trillion worth of debt across the globe was yielding negative returns, and this was even before the European Central Bank (ECB) pushed its deposit facility rate further down by 10 basis points to -0.5 percent in September 2019.

Of course, as said before, this phenomenon is becoming more widespread around the world, in fact, not only the ECB has entered the negative interest territory, but also the central banks of other advanced economies have adopted the same measures, including the Bank of Japan (BOJ), the Swiss National Bank (SNB), and Sweden’s Riksbank.

Euro Area Deposit Facility Rate (DFR) — (source: Tradingeconomics)

In general, the greater diffusion of negative interest rates among major economies is a part of a broad trend where central banks are either continuing with existing loose monetary policy or are cutting rates as the growth outlook dims and inflation remains below the target value, like in the case of the Federal Reserve, that has cut the federal funds rate by 25 basis points and followed that with another similar cut in September.

As highlighted before, negative interest rates are an instrument of unconventional monetary policy that refers to a scenario in which cash deposits, rather than producing income, incur a charge for storage at a bank.

This means that depositors, instead of receiving an income from their deposits, usually in the form of interest, will have to pay regularly in order to keep their money in the bank.

Negative interest rates are often the result of an extreme and sometimes desperate effort made by the Central Bank in order to try to stimulate the economy in periods where the economic growth slows down.

In an environment like that, the adoption of negative interest rates could be beneficial in order to try to stimulate lending, aggregate demand, and spending.

Even if its effects are in some ways still unknown, central banks adopt negative interest rates, as said before, to kickstart the economy in periods like the one we are in today, where economic growth slows down and most central banks have already lowered their interest rates near the level of zero, and therefore have almost no room to decrease it even further.

Their effect as a stimulus for the economy should come from the fact that commercial banks, that have a deposit within the central bank, will have to pay interest for the excess cash that they deposit.

The idea that they will have to spend to deposit money at the central bank should encourage them to lend that extra cash, at low rates, to businesses and other actors in the economy. Banks should be interested in doing so because from the lending activity they have the possibility to earn some returns on their cash, while if they keep it within the Central Bank, they will lose money.

Why have they been implemented?

As I said in the first part of this section, negative interest rates are instruments of unconventional monetary policy, which is a group of activities implemented by central banks in recent years in order to try to stimulate the economy, in areas and situations where the conventional methods seem to be almost ineffective. They are for example credit easing, quantitative easing, and forward guidance.

The adoption of these instruments by major central banks around the world has become more widespread since the global financial crisis of 2007/2008, which is considered by many economists to have been the most serious since the Great Depression of the 1930s.

It has also been the most severe crisis since the introduction of the fiat currency system around the world, which in recent years is generating much more interest than before.

With the fiat monetary system, the value of a currency is not based on any physical commodity but is instead allowed to fluctuate dynamically against other currencies on the foreign-exchange markets.

It is a relatively recent introduction, in fact, prior to the Nixon shock of 1971, the model that was generally used was the Bretton Woods System, which established a system of payments based on the U.S. dollar, and defined all currencies in relation with to the dollar which was itself convertible into gold.

What are its effects?

The overall effects that the adoption of negative interest rates have had on the economy are hard to completely assess right now, in fact, as said before they have been introduced just a few years ago, therefore we need a larger amount of data in order to have a better understanding of the real effects that these policies have had on the economy.

However, I think is very important for everyone to understand these macroeconomic mechanisms because even if they seem far away from our everyday life, they have a great impact at every level.

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