An interest rate is effectively the cost of borrowing, which the major central bank determines. This means that the lender charges a borrower interest when they take out an type of debt. However, a negative interest rate environment is where those lenders may end up paying borrowers when they take out a loan.
Interest rates tell you how valuable money is today compared to the same amount of money in the future. A positive interest rate implies that your money today is worth more than it will be tomorrow. Inflation, economic growth and investment spending contribute to this outlook. However, a negative interest rate implies that your money will be worth more, rather than less, in the future.
In a negative interest rate:
- Savers would have to pay interest to their bank, rather than receive it.
- Borrowers would be paid to do so instead of paying their lender.
This would promote consumption and investment instead of saving.
Central banks in Europe, Scandinavia and Japan have implemented a negative interest rate policy on excess bank reserves in the financial system over the past two decades.
A negative interest policy sets the nominal target interest rates with a negative value below the theoretical lower threshold of 0%.
While unorthodox, this tool aims to spur economic growth through spending and investment, rather than through hoarding. The NIRP is a way to incentivise corporate borrowing and investment and discourage the hoarding of cash when the economy performs poorly (especially during periods of economic recession or depressions).