Question

Explain why households or firms will still be willing to buy bonds that yield a negative return or to save into bank accounts that pay negative interest rates.

Explain why negative interest rates will make it extremely difficult for central banks to conduct expansionary monetary policy by setting lower target cash rates.

Answer 1

Negative interest rates are basically those rates at which instead of earning money on deposits, banks are charging for storing money. So it refers to the scenario in which instead of receiving income on deposits in the form of interests, the depositors have to pay some money to the bank in order to retain their money.

The negative interest rates leads to a charge for the depositors for holding money rather than paying them interest on those deposits. Basically I happens in a situation of deflationary situations, where people are wanting to save money rather than spending it in the economy. This may lead to a very much fall in the aggregate demand, and due to this price may fall to even lower.

So the question arises, why do people still want to invest in banks and save more money even when they are charging negative interest rates:

1. Cash safety for the depositors is the first reason, some people want to save their cash in bank instead of transacting that money in the economy, they feel that their cash is safe there by just paying a nominal price for it.
2. Liquidity is the most common phenomenon that people and business people have, they want instant liquidity for their cash and cash purposes, so banks and savings are the best option available to them in this case.
3. During period of recession, people are more into saving and locking their money instead of spending, this may happen because of speculator motive and necessity motive of using money.

So basically, when people find it more expensive to spend money in the economy rather than giving a nominal charge to bank for saving their money, situation arises that people invest in banks during negative interest rates.

Expansionary monetary policy is the policy that a central bank uses to stimulate the economy, increases the money supply, lowering the interest rates and taking measure to increase the aggregate demand in the economy. During the negative interest rates, the rates are already negative in the economy and the central bank cannot take any such measure that directly put a downward pressure on the interest rates.

So the government should have to take several measures that stipulate the aggregate demand in the economy. Hence the scenario makes it very difficult for the government to conduct expansionary monetary policy during recessionary phases. There is always a level of interest rates in the economy which the government has to maintain in order to keep economy going. So in such cases government can take various measures that help in increasing aggregate demand in the economy, like increasing awareness among people why it is important to consume, bringing on FDI (foreign direct investment) in the economy to increase demand and employment levels in the economy.