Free Custom «Interest Rates» Essay Paper

Introduction

A negative interest rate is an unconventional monetary policy where banks require depositors to pay regularly to keep their money with the bank as opposed to receiving money on deposits. The paper will lay emphasis on how negative interest rates can affect the NPV of a project, as well as its ramifications on the savings account. It will also culminate in a succinct explanation on how interest rates can affect the entire U.S. economy.

Discussion

Interest rates can be negative as a bank can charge depositors for saving money when the economy is contracting as it can be detrimental to the economy (Financial Times, 2014). In fact, the central banks of Sweden, Denmark, and Switzerland are already operating under negative interest rates (Financial Times, 2014). The aim of negative interest rates is to provide cheap liquidity as an incentive to encourage people to indulge in economic activities (Financial Times, 2014). For instance, a bank can set its key rate at -0.2%, which implies that bank depositors will have to pay 0.2% of their deposits instead of receiving a positive interest. The correlation between negative interest rates and Net Present Value (NPV) in this context will be premised on the fact that borrowers are rewarded by the bank (Eisenstein, 2011). Therefore, taking a loan from a bank will be an equivalent to an investment, as one will pay less than the initial loan amount.

It will affect the NPV in the sense that annuities paid towards a loan will reduce as the borrower will pay less as a result of the reward for borrowing money (Brown, 2015). Besides, NPV will increase due to the fact that a negative interest rate means that the money borrowed today will be less than the same amount in the future. For instance, if the bank lends $1,000, it will reward the borrower, thus receiving less than $1,000 after the end of the borrowing period. It means that the NPV will be higher, while the annuities paid by the borrowers will be lower as they are not paying the full amount of the loan.

Negative interest rates influence the savings account in a way that savings themselves become costly. For this reason, people who prefer saving will be penalized and their money will be deducted as per the prevailing interest rate. As a result, the best option will to withdraw money from the savings account and use it for the available investment opportunities (Financial Times, 2014). Moreover, negative interests will be beneficial to the United States economy as the entrepreneurs can borrow and receive additional capital to start their businesses, which will spur economic growth. However, negative interest rates might also be a precursor to deflationary pressures, whereas the lower cost of capital will enhance excess investment capacity (Donovan, 2015). The ramifications are reduced prices for goods and services.

There is also a likelihood that negative interest rates will ruin banks due to the ‘mattress effect’, where consumers prefer to save their money in mattresses or secure vaults (Brown, 2015). Moreover, if everyone withdraws their money, banks will not have funds to lend. Besides, banks earn make money from interest rates they receive from lending. Therefore, with negative rates, banks are not obtaining money and it might be detrimental to financial institutions (Donovan, 2015). The rates might also devalue the currency by making exports cheaper and imports more expensive (Brown, 2015). It makes exports more attractive to foreign trade, thus increasing jobs locally as companies strive to increase foreign demand.

Conclusion

Negative interest rates become a common phenomenon in the modern world of finance as they are being applied in some parts of the country. The idea behind imposing negative interest rates is to encourage investments and enhance economic growth. However, the negative rate can cause deflationary pressures, currency devaluation, and a consolidation of smaller financial institutions.