In most countries around the world, there's a central bank that has a number of tools at their disposal to influence the country's economy. One thing that the central Bank has control over is the federal funds rate, which is essentially the interest rates that banks charge other banks to lend money. This federal funds rate in turn, affects the interest rates that consumers may get on their loans. If a federal funds rate is low, then a bank can borrow money at a pretty low rate.
Meaning that it can also lend money at lower rates and still turn a profit. If the federal funds rate is high, then it costs banks a lot of money to borrow money, meaning that in turn they have to charge higher interest rates on loans to turn a profit. That's some simple background on the federal funds rate, but let's take a look at what the Federal Reserve or Central Bank can actually do if they adjust it.
Interest rates are one of the biggest levers that the Central bank can use to adjust the monetary policy in a country. Adjusting it sets a guide for how banks and lenders will lend to the rest of the population. However, this has far reaching effects far beyond what you pay in interest on a car loan. The central bank can raise rates if it wants to help stop inflation in the economy. Higher interest rates makes borrowing money, more expensive, thus making products more expensive, since it costs individuals more to borrow money to make or buy them. It also makes saving your money a lot more attractive, as you'll likely earn a higher return if you just hold on to it. If the central bank lowers interest rates, it encourages spending. It makes getting more money cheap, meaning businesses and individuals can easily spend more lower interest rates also discourage saving, as keeping your money sitting in a bank account will yield less in theory than going out and spending it on investments, businesses, or goods. In recessions, the Central bank will lower interest rates to encourage people to go out and spend to stimulate the economy. So we've laid out the basics of how the central bank can manipulate the economy with the federal funds rate. But what if the rate goes negative? Don't negative rates mean that you get paid to borrow money?
Yes, yes they do. Negative rates are like a hyper boost to the economy, but they can and may be dangerous. When the economy of a country is looking rather bleak, much like many of the world's economies right now at the time of recording, central banks may consider setting interest rates to negative values. When economies downturn, people naturally save up their money to protect themselves in case they lose their job. However, if they know they could just get money easily through a loan at a hard time, they might be more willing to spend if people do end up stockpiling their money, then economies can experience deflation conversely to inflation, which makes goods more valuable. Numerically, deflation happens when people stop spending, demand for goods drops and thus the prices of the goods must also drop, so people still buy them supply and demand. When a deflation cycle happens, it can be hard to stop until there's a lot of pain. For businesses and the larger economy, negative interest rates are the biggest weapon that can be used to fight back against deflation, or in other terms the biggest weapon to make people spend their money and stimulate the economy. When interest rates are negative, it ultimately makes holding on to money expensive. You'd have to pay a bank to put your money in it. Likewise, banks would have to pay each other to take their money. Negative interest rates makes having money expensive, meaning you should go out and spend it or invest it in business, while the United States has never set negative interest rates into action. Many established economies around the world have countries in Europe and Japan.
Back in 2014, the Central Bank of Europe or the European Central Bank set in place an interest rate of -.1%. Today the rate is now -.5%. The Bank of Japan also historically set extremely low rates, but it wasn't until 2016 that they set their first negative interest rate. Today they have a negative interest rate of minus .1% wih no signs of shifting that back to positive. Once a central bank goes negative, it's rather hard for them to shift the rates back to positive because it signals a complete shift in how the economy functions. One based around spending and lending when there are negative rates, and one based around saving when there are positive rates. All of this is a lot of economic theory, though in actuality, negative rates may and can actually be damaging, some research has found little evidence that negative rates in Europe actually encouraged families to go out and spend. Conversely, there's also been research that does say they did work. All this said, negative interest rates probably do something, but danger can set in if central banks are never able to set them back to positive. Negative rates are for too long and can cripple financial institutions capabilities to make money. They can cripple individuals abilities to save money as well and over time can lead to greater government debt as more is needed to keep the economy moving. Because negative interest rates are a fairly new monetary tool. In regards to all of financial history, the evidence of their effects is fairly mixed. Japan's negative interest rates seem to work at first, but now their effect seems to have faded. Prices of goods are falling into the bank has little more power to stop it because the rates were already negative. Conversely in Europe and Japan. Negative rates did seem to work initially, which suggests that maybe negative rates coupled with other financial policies might actually work to stimulate a dying economy. In summary, negative rates are one of the most powerful tools that central banks have to fight back against a dying economy. While there's still mixed results in regards to their long term effects, They do seem to work initially as a stimulus measure. While you as the consumer will likely initially benefit from negative interest rates, they can have some damaging long term effects too. When it's cheap for you to borrow money, that also signals to manufacturers and sellers that they can raise prices. When it's cheap to get a mortgage, home prices can be driven up. Ultimately balancing out the equation for you, when it's cheap to get a car loan, cars end up costing more. Negative interest rates are a last ditch effort of central banks to stimulate economies and now hopefully you understand a little bit more about what they do and what they mean for you.
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