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The Negative Side of Interest Rates
Subject Monetary Policy
Topic Monetary Policy
Key Words Interest Rates, Deflation, Real Interest Rates
News Story

Interest rates in Japan are very close to zero. Yet, with continuing deflation and the threat of a banking crisis the Central Bank of Japan is considering lowering interest rates still further. This would bring interest rates below zero. What is a negative interest rate? It occurs when depositors have to pay banks to hold their savings.

Interest rates in Japan have been falling since 1991. In 1999, the Bank of Japan started pushing short-term interest rates close to zero and, as a result, savers have earned virtually no interest on their deposits. Ordinary savings accounts presently earn .001 percent annually.

Two factors are important in the Central Bank of Japan's deliberations that would bring about below-zero interest rates. The first is Prime Minister Junichiro Koizumi's plan to limit government guarantees on savings to 10 million yen, about $83,000, on each account. Currently, accounts are insured for the entire amount of the deposit. This modification is similar to the Federal Deposit Insurance Corporation's policy in the United States. With confidence in Japan's struggling financial sector ebbing, savers might be willing to pay to guarantee their savings.

Another consideration that might lead Japanese savers to actually pay banks to hold their savings is the lack of faith in the stability of the financial sector. One of the key elements in Mr. Koizumi's platform was the proposed reform of the financial sector. Because of the number of bad loans banks are currently carrying, meaningful reforms would entail dissolution of a number of banks. To date, these reforms have not been undertaken and there is concern that a significant number of bank failures may cause significant problems.

What makes zero-interest savings somewhat tolerable is Japan's continuing deflation. Accounting for falling prices, real interest rates are actually positive. However, zero-interest savings is a problem for pensioners and others who live off interest income. As their interest income decreases, many cut back on purchases, weakening the economy. The contemplated interest rate cuts will make their position worse.

(Updated September 1, 2002)

Questions
1. What is the difference between real interest rates and nominal interest rates? If current interest rates are zero, how can real interest rates be positive?
2.

According to the article, what two reasons are given for considering further cuts in interest rates?

3.

What effect would lowered interest rates have on the exchange rate between the dollar and the yent?

Source Ken Belson, "Below-zero interest considered in Japan" The International Herald Tribune, August 7, 2002.

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