I understand that this is designed to stop deflation, but what does it mean practically speaking?
In: Economics
If you are a bank or large lender and someone wants to borrow money from you, say to buy a house or a car, you as the bank can go to the central bank (bank of England, federal reserve etc.) and ask for a loan. The central bank charges big borrowers the prime rate. Say 1%. The bank then charges the customer money, say 2%. The bank makes a profit on the spread between the rate they pay and the rate you get. Some percent of loans default and they have a cost to administer the loans so it’s not pure profit.
The money supply is then determined by how many people want to borrow new money at this prime rate, versus borrowing it from someone else at a potentially lower rate. If you could make 1% lending your money to the government or 1.5% to people buying cars, you might lend to people buying cars and they would take that deal vs 2% from someone else.
A negative interest rate means the central bank is paying large commercial borrowers (banks, mortgage companies, large car companies) to borrow money. Say – 0.5% means they are paying you half a percent to have borrowed money. Rather than paying back 100% of a loan you might only pay back 99.5%.
This runs into what is called the zero lower bound. Loans to customers can’t make money at 0% or less, so even if the natural rate of interest due to deflation is lower than 0%, end user rates can’t go below 0. Maybe they can but no one really sorted out how to make that work.
Japan had negative interest rates because the expectation was that money would have more buying power later. If you had 1000 dollars just sitting in a mattress would buy more in future than it does today, you would wait to spend. And if you wait to spend and I wait to spend and no one spends the economy stagnates. Imagine you know a playstation is 500 dollars today, but will be 450 dollars next year. But rather than a playsration it’s everything, including business investments and government spending like roads and factories and so on..
Central Banks cut rates to encourage borrowing, since it makes it cheaper and lower risk for people to spend. Most of the west just spent almost 15 years with low rates after the dot Com bubble and then the 2008 financial crisis. But those rates all bumped into the problem of: if you are lending money at 0% interest, and people still aren’t buying things how do you get them to start purchasing? And then of course post pandemic we have seen a major run up in interest rates because the economy needed a major realignment post pandemic, that discussion will possibly be a whole new area of economic research though.
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