What is Interest Rate?

Interest rate is the compensation paid by the borrower to the lender to cover the risk and inconvenience of not having their money with them.

Cost of borrowing/Interest rate is a percentage of the sum loaned.

Policy Rate:

Central Banks use interest rates as a tool to influence growth, employment and inflation.

If Banks need funds to meet their short-term requirements, they can borrow from the Central Bank at a rate of interest (also called policy rate) which is decided by the Central Bank. In India, this rate is called the Repo Rate.

Banks tend to keep their surplus funds with the Central Bank and earn a rate of interest (also called the policy rate). In India, this rate is called the Reverse Repo rate.

Central banks tend to use the policy rates to bring about desired changes in the economy:

In case of economic growth rate and inflation above the target of Central Bank –> Central Bank increases interest rates –> Makes it expensive to borrow to spend and invest –> which decreases demand for goods and services –> slower economic growth.

In case of a slowdown in an economy and inflation below the target of Central Bank –> Central Bank decreases interest rates –> Makes it cheaper to borrow to spend and invest –>which increases demand for goods and services –> Higher economic growth.

But in case the slowdown is very deep, bringing down the interest rates to zero might not be enough and the Central Bank may take policy rate below zero. (Negative Interest rates)

Banks will now have to pay to the Central Bank to deposit their excess cash with it. The motive of Central bank is to nudge Banks to lend instead of hoarding funds.

Will the banks also make interest rate negative for its depositors?

Ideally no. Because many individuals and small businesses who have smaller sums will withdraw their deposits from banks and keep it under their mattresses. Why would an individual pay to bank to keep its own money.

But entities which have taken loans from the Bank would demand a lower interest rate on their loans as overall interest rates have fallen in the economy. Thus, Banks will earn a lower interest rate on its loans which will bring its interest margins under pressure. This will affect Banks’ profitability and putting pressure on them.

Negative interest rates penalise savers and would result in transfer of wealth from savers to borrowers. It will hit hard people who have retired and are dependent on their savings.

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