Article contributed by Dr. Deep Chandra Oli, Associate Professor, Faculty of Commerce and Business Management
In the common parlance interest has been defined as the price or cost of capital or cost of money .The underlying postulate in economic theory is the scarcity of resources .Interest is paid when one uses someone else’s money this is the edifice on which entire economic theory has been architect. The borrower agrees to pay the lender for using money provided to borrower . In other words borrower compensates the lender by paying interest for keeping him out of funds for a certain period .
Economists have designed many theories to understand the predicament of interest like supply and demand of money or supply of savings and demand of investments . These all theories intrinsically indicate and drive people towards savings . Savings earn interest for savers . Higher the continued term of savings higher rate of interest is the maxim. Eventually inflation (continued rise in price of commodities) also becomes key driver for long term rate of interest for the savings. Such prescription of rate of interest is termed as Nominal Rate of Interest. Nominal rate adjusted for inflation is Real Rate of Interest . This is actual earning for the lender which also takes care of opportunity cost of savings
There are many interest rates in vogue like money market interest rates, call money rates but most important of those is policy interest rate (repo rate in India) . It is a signal rate prescribed by Central Bank of country and a direction for borrowing costs . Higher policy rates prove an incentive for savings but increase the cost of investments . On the other hand , lower policy rates incentivise consumption and reduce the cost of investments. Policy rates which neither stimulate nor restrain economic growth are termed as Neutral Interest Rates which stand in favour of stable long term rates and stable long term inflation rates as well . In case of policy rate being declared as less than neutral rate the monetary policy of the country is categorised as Expansionary . A higher policy rate than neutral rate is termed as indicator of Contractionary Monetary policy .
Economists have attributed the downward and generally lower than expected trend of Neutral policy rates to long term demographic trend of society (Aging population),weak productivity growth and scarcity of risk free assets and persistently low inflation in Advanced Economies further consolidates the sentiment of downward expected inflation in future periods . In fact these factors have pushed the policy rates to the so called lowest bound of Zero Percent Interest Rate on Government Securities and Bonds .
Post Global Financial Crisis the Central Banks have cut Nominal Interest rates aggressively to Zero or close to Zero . At present policy rates /Nominal Rates are zero in France ,Germany , Italy ,Netherlands and Spain . Central Banks and Governments , in pursuation to ”Growth at all costs “ approach and persistent obsession to growth ,have incentivised spending rather than savings and investments in riskier proposals than Bank FDRs/Money Market Mutual Funds .
In 2014 ,for the first time European Central Bank decided to pay Negative Rate of Interest to Commercial Banks for deposits held by Commercial Banks . Bank of Japan followed the suit .Consequently European and Japanese Government Bonds witnessed the Negative interest rates . US Federal Reserve moved in tandem for many years . Denmark also saw negative rate of interest on Mortgage Loans(below five years) and Banking there witnessed borrowers simply paying meagre upfront fees and receiving a “Thank You “ payment every month.
Researchers have concluded that persistently low interest rates have caused a concern for banks for low profitability. . These were not found to have relationship with economic growth . But these have led to increase the value of assets ,Bonds ,real assets and other risky assets. Central Banks must design well thought macro economic policies attacking price stability, unemployment not only inflation .
Hakshar V. And Kopp Emanual . A.(2020) , How can interest rate be negative? ,Finance and Development ,March2020,pp-50-51.
Dhingra Gautam and Oslon Christopher j (2019) ,Negative Interest rates: Carry an umbrella at all times ,http://blogs :cfa:institute.org /investor/2019/07/23
Melanie Klein(2016)Implications of negative interest rates for the net interest margin and lending of euro area banks ,https://www.weforum.org/agenda/2016/11/negative-interest-rates-absolutely-everything-you-need-to-know/