In the contemporary financial environment, individuals who deposit money in the banks earn interest from their deposits. Similarly, commercial banks also receive interests from lodging funds with central banks. In other words, banks compensate savers by adding some percentages of the amount saved in the banks. In a sense, savers are lending their money to banks in order to be used elsewhere. In return, banks compensate savers interest incomes. Meanwhile, the interest rates are quoted as APY (annual percentage of yield) and savings account earns 3% APY. However, negative interest rates reverse this arrangement where savers or depositors are obliged to pay banks for holding their money. Moreover, central banks penalize commercial banks for depositing their funds with them. For example, The ECB (European Central Bank), some smaller European banks, and Bank of Japan have introduced the negative interest rate policy where banks, as well as other financial institutions, will have to pay charges for allowing central banks to keep their money. However, there are genuine reasons for introducing this policy.
The objective of this policy paper is to investigate the reasons for introducing the negative interest rates and the risks associated with the policy.
Reasons for Introducing Negative Interest Rates
Since 2014, the ECB (European Central Bank) has become the first major bank that has moved out of the traditional marginal policy to the negative interest rate policy to address the macroeconomic challenges and achieving price stability. The major goals for introducing the negative interest rates are to counter low inflation rates, and addressing currency appreciation pressures. Some central banks introduce negative interest rates to reduce the cost of holding excess reserves and allowing the reserve to pass through money markets. For example, Japan and Eurozone introduced the negative interest rates to anchor inflation expectation and address price stability. In Denmark, the goal is to counter exchange rate pressures and safe haven inflows. However, Switzerland objective's for introducing negative interest rate is to reduce deflationary and appreciation pressures.
Barua and Majumdar (2016) point out that the interest rate of ECB (European Central Bank) is below zero. However, data in Eurozone reveals that ECB has recorded successes from negative interest policy because banks and households are recovering from the sovereign debt crisis and global financial crisis.
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The unorthodox policies assist in pushing up the aggregate demand, and liquidity thereby pushing the prices up and stimulate firm propensity to initiate capital investment. A robust argument in favor of negative interest policy is to counter deflation, forcing banks to lend more thereby reducing their excess reserves. A way of using the negative interest policy is to boost economic growth since banks naturally do not like to hold excess reserves and prefer lending out their cash reserves. However, during the period of financial risks, banks will prefer putting their excess reserve with the central banks, Thus, when banks are discouraged from putting their reserves with the central bank, the alternative left for them is to lend out their funds thereby boosting the aggregate demand and investments. Thus, the major goal for introducing the negative interest rates is to encourage commercial banks increasing their lending capacity thereby stimulating economic growth. The strategy will encourage commercial banks to invest their excess reserves in the public. Since commercial banks and other financial Institutions have realized that they will lose part of their funds by depositing them with the central banks, they will be forced to lend out their funds to the public. In this sense, the central banks use the negative interest rates to stimulate the sagging economies. More importantly, when depositors realize that they are not going to get benefits from depositing their funds in the commercial banks, they will prefer spending the funds rather than allowing the funds eroding over time. (Weing, 2015).
The goal of negative interest rate is also to discourage banks and other financial institutions from hoarding their cash and be forced to invest their funds or lend them out. Jobst, & Lin (2016) argue that "the European Central Bank (ECB)" (p 1) introduced a policy of negative interest rates to achieve price stability since it is currently contributing to a modest credit expansion.….....