Interest rate defines the rate at which a borrower pays interest on a loan‘s principal amount from a lender. Every loan transaction will include an interest rate. For borrowers, lower interest rates are preferable as it means they have to bear lower expenses. On the other hand, lenders will prefer their interest rates to be higher as it suggests they will get higher returns.
Usually, the lender decides the interest rate on a loan transaction. They consider various factors while establishing the percentage. Most importantly, lenders account for their risks for any loan transaction by setting the interest rate. Interest rates are generally positive. In some instances, however, they may also be negative. Negative interest rates may sound impossible, but it is still possible.
What is a Negative Interest Rate?
Negative interest rates occur due to a country’s monetary policies. Usually, a country’s central bank dictates these policies. Therefore, the bank may, in some circumstances, set the interest rates to be negative. While these cases as rare, they may still occur. With negative interest rates, the central bank can decrease the borrowing cost prevalent in the economy. Through this, the bank can increase economic activity.
Negative interest rates sound counterintuitive. While these may be costly to the government, they can also be beneficial. Negative interest rates allow the central bank to control the economy during economic recessions. Usually, it causes investors to obtain loans and use them towards investments. Similarly, people may use loans for other activities, which generally increases the consumption in the economy.
How does a Negative Interest Rate work?
With usual interest rates, a lender provides a borrower with a loan. After a predetermined period, the borrower pays interest to the lender. This interest depends on the interest rate set on the transaction. However, the same does not apply to negative interest rates. After the predetermined period, the lender pays the borrower interest.
Therefore, with negative interest rates, borrowers actually earn income rather than bear expenses. The lender, on the other hand, suffers expenses related to the interest rate. As mentioned, however, the lender, in this case, is the government or the central bank. These entities usually have other benefits they receive from paying interest on the loans they provide.
During specific circumstances, such as recessions, people usually accumulate money. They refrain from investing or spending the money. It causes the aggregate demand in the economy to decline. During these periods, the central bank can use negative interest rates to encourage investments. This strategy is a part of the monetary policy.
What is the impact of the Negative Interest Rate?
The negative interest rate encourages most commercial banks to borrow more. It is because they can earn on these loans. In turn, these banks also decrease the interest rates in the market. The lower or negative market interest rates attract more investors and individuals to obtain a loan. Through investments and spending, they contribute to the country’s economic activity.
The above is the intended impact of a negative interest rate and can lead to increased aggregate demand. Apart from that, the negative interest rate may also affect a country’s economy. Negative interest rates also influence the forex exchange rate. Due to the decrease in interest rates, a country’s currency value falls. This devaluation can promote export activities in the country.
Interest rates are the percentage that lenders charge on their loans. In some cases, these rates may be negative as well. Negative interest rates are a part of a country’s monetary policy, dictated by its central bank. With these rates, borrowers can earn interest income rather than bear expenses. A negative interest rate can have several impacts, as discussed above.