How Can Interest Rates Be Negative?

• Author: Vikram Haksar and Emanuel Kopp
• Position: VIKRAM HAKSAR is an assistant director and EMANUEL A. KOPP a senior economist in the IMF's Strategy, Policy, and Review Department.
• Pages: 52-53

50 FINANCE & DEVELOPMENT | March 2020

BACK TO BASICS

How Can Interest Rates Be Negative?

Central banks are starting to experiment with negative interest rates to stimulate

their countries’ economies

Vikram Haksar and Emanuel Kopp

ART: ISTOCK / RASTUDIO

MONEY HAS BEEN AROUND for a long time. And we

have always paid for using someone else’s money

or savings. e charge for doing t his is known

by many dif‌ferent words, from prayog in ancient

Sanskrit to interest in modern Englis h. e oldest

known example of an inst itutionalized, legal inter-

est rate is found in the Laws of Eshnunn a, an ancient

Babylonian text dating back to about 2000 BC.

For most of history, nominal interest rates—st ated

rates that borrowers pay on a loan—have been pos-

itive, that is, greater tha n zero. However, consider

what happens when the rate of inf‌lation exceeds

the return on savings or loan s. When inf‌lation is

3 percent, and the interest rate on a loan is 2 per-

cent, the lender’s return after inf‌lation is less t han

zero. In such a situation, we say the real interest

rate—the nomina l rate minus the rate of inf‌la-

tion—is negative.

In modern times, central banks have cha rged

a positive nominal interest rate when lending out

short-term funds to regulate the business cycle.

However, in recent years, an increasing number

of central bank s have resorted to low-rate policies.

Several, including the Eu ropean Central Bank and

the central bank s of Denmark, Japan, Sweden,

and Switzerland, have sta rted experimenting with

negative interest rates—essentially ma king bank s

pay to park their excess cash at the central ban k.

e aim is to encourage ba nks to lend out those

funds instead, t hereby countering the weak growth

that persisted af ter the 2008 global f‌inancial cr isis.

For many, the world was turned upside down:

Savers would now earn a negative return, while

borrowers get paid to borrow money? It is not

that simple.

Simply put, interest is the cost of credit or the

cost of money. It is the amount a borrower agrees

to pay to compensate a lender for using her money

and to account for the associated ri sks. Economic

theories underpinning interest rates vary, some

pointing to interactions between the supply of

savings and the dema nd for investment and others

to the balance bet ween money supply and demand.

According to these theorie s, interest rates must be

positive to motivate saving, and investors dema nd

progressively higher interest rates t he longer money

is borrowed to compensate for the heightened risk

involved in tying up their money longer. Hence,

under normal circumsta nces, interest rates would

be positive, and the longer the term, the higher t he

interest rate would have to be. Moreover, to know

what an investment ef‌fectively y ields or what a loan

costs, it important to account for inf‌lation, the

rate at which money loses value. Expectations of

inf‌lation are therefore a key driver of longer-term

interest rates.

While there are ma ny dif‌ferent interest rates in

f‌inancial markets, the policy interest rate set by a

country’s central bank provides t he key benchmark

for borrowing costs in the countr y’s economy.

Central bank s vary the policy rate in response to

changes in the economic cycle and to steer the