For hundreds of years, banks have operated in a positive interest rate environment – in which they...

Question

For hundreds of years, banks have operated in a positive interest rate environment – in which they receive interest payments on the amount of reserves they keep at central banks, and they charge borrowers a lending rate greater than the deposit rate they pay depositors. As a result, the larger the interest rate margin, the higher banks’ earnings.

In recent years, central banks in many developed countries have lowered official interest rates, all the way to negative territory, and recently banks in some Scandinavian countries have started tochargedepositors andpayborrowers. This is something of a first in the history of banks.

In this assignment, you are asked to contemplate the phenomenon of negative interest rates. More specifically, to discuss the possible effects of these negative rates on banks’ activities, risk taking behavior, and performance. Finally - what will be the broader macroeconomic implications of these phenomena?

econ335-task-drabjkno.pdf

Alomita · Accepted Answer

THE PHENOMENA OF NEGATIVE INTEREST RATE :
Negative interest rates occur when a significant amount of price is required by the bank in order to store the cash deposits . The customers have to pay the charge regularly in order to keep their money in banks and does not receive any interest on their income Since the 1990s interest rates have declined and are still declining  .  This phenomena occurs during deflationary periods when people and businesses hold too much money instead of spending which  results in a sharp decline in demand, and prices falls to their lowest . The entire economy faces the impact of negative nominal interest rates and banks and other firms have to pay to store their funds at the central bank, rather than earn interest income. 
Since 2007 , the financial crisis taking place forced many countries to take up monetary policies .  To stimulate the economies characterized by low growth and low inflation, the central banks, including the European Central Bank (ECB) and the central banks of Denmark, Switzerland, Sweden, and Japan, have  adopted negative policy rates. The  objective of the negative rates were to   provide additional monetary stimulus, giving banks an incentive to lend to the  economy and in this way support growth and  target  to reduce inflation. As a result, banks would lend to riskier borrowers without being fully compensated for it . The implied  price inflation determines financial stability  and crowd out private investment. Crowd out or crowding out effect can be described as an economic situation where the increased interest rates leads to a reduction of private investment thus dampening the initial investment or total investment in the economy.  such cases the government adopts some expansionary fiscal policy measures in order to curb down this effect and which helps to boost the economic activity on the nation. This leads to an rise in the interest rates which affects the private investment decisions made by the private investors of the nation. A high magnitude of crowding out effect may even lead to lower income in the economy  and instead of boosting the economic activity , the economy falls. The price paid for the funds and shares which are to be invested, increases due to high interest rates and affects their accessibility to debt financing mechanism.
POSSIBLE EFFECTS OF NEGATIVE INTEREST RATES ON THE ECONOMY :
Warren Buffet said that interest rates are like gravity which means that if  there is no gravitational pull on asset values, then the pertaining values can be infinite in numbers . This statement was unknowingly said by Warren Buffet,

For hundreds of years, banks have operated in a positive interest rate environment – in which they receive interest payments on the amount of reserves they keep at central banks, and they charge...

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