What is Negative Interest Rates Explained – As the world tumbles toward recession as a result of the coronavirus pandemic, the Trump Administration and the Federal Reserve are leaning into an unusual financial strategy in hopes of jump-starting the US economy: negative interest rates.
What Are Interest Rates?
Interest rates are the percentage of a loan you pay to a bank as a fee for borrowing their money. It’s also the rate that you earn for saving your money when you deposit it into a savings account. In short, a normal interest rate will cost you for borrowing money, and reward you for saving it.
Meanwhile, your bank will store some of its deposited cash with the Federal Reserve, the United States’ national bank. When the economy is good, the Fed’s rate is high, encouraging banks to save more money with them. But when the economy stalls, the Fed will lower the rate for banks, discouraging them from saving money in favor of incentivizing them to spend.
So what happens if interest rates descend below zero?
In theory, negative interest rates would mean that borrowers are paid, by the lender, to take out loans. For example, a typical $100 loan with an annualized 2% interest rate requires the borrower to pay back the bank $100 plus $2 interest within a year. But a negative interest rate, say -2%, might imply that a borrower who pays back his $100 loan would be paid an additional $2 by the bank.
Being paid to spend money may sound too good to be true, but negative interest rates have already been implemented by some of the world’s wealthiest economies. After the 2008 financial crisis, Sweden’s was the first economy to experiment with negative interest rates. Since then, Japan, the European Central Bank, Denmark, and Switzerland have all followed suit.
Why would banks pay people to spend money?
Negative interest rates theoretically incentivize borrowers to spend money. A lending bank will have to pay more to park its cash with a central bank, but be rewarded for lending it to borrowers. This trickles down to everyday borrowers, who would be penalized for saving money in a savings account, but rewarded for spending their money. Moreover, since borrowers will be paid to take out loans, they are more likely to take money out of the bank and put it into the economy. More money in circulation will tend to revive a sagging economy.
In other words, negative interest rates would encourage banks and borrowers alike to spend money and feed the economy, as opposed to saving money and starving the economy.
Why the push?
During times of economic uncertainty, most people feel anxious about their financial stability, and hold onto their savings like a security blanket. It’s intuitive, after all, to stop spending money if you don’t know how financially stable you’ll be in a few months.
But economies are fueled by spending. When people stop putting money into the economy, business suffers forcing employers to cut workers while lowering the price of their services or goods. Ultimately, profits in every sector plummet. And the worse the economy does, the more likely people are to save their money, perpetuating a vicious downward cycle.
Hence, negative interest rates are widely viewed as a cure to money-hoarding. If people are given an incentive to borrow and spend, the economy gets a boost and begins to heal.
One potential drawback to negative interest rates is that banks may curtail lending in certain fields, notably mortgages. Banks make money by collecting interest on these loans, and if negative interest rates prevent banks from earning on mortgages, they will be discouraged from granting mortgages to most borrowers.
Another potential danger is that borrowers will take out loans, but not spend their money. Negative interest rates alone cannot ensure that people will actually put cash back into the economy. Therefore, it’s unlikely that this solution will boost the economy unless it is paired with other incentives for spending.
Finally, if an immense number of borrowers rush banks to take out loans, banks could run out of money, forcing interest rates to rise. Broad oversight on behalf by the federal government is essential to ensuring that the flow of money is not suddenly impeded by increased demand for loans.
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