BoJ makes its key interest rate negative!

This move should be of great interest to all 12th graders with its implications for demand-side macro policies and for international exchange-rate movements. But 11th graders should also notice that an interest rate is really the “price of money”. Those who demand money (borrowers) need to pay the price and those who supply money (the lenders) expect a price to be paid. Now it appears that we can have negative prices–so the vertical axis on a demand and supply axis may need to be redrawn!

What happened?

Japan’s central bank (Bank of Japan) surprised economists on Friday by effectively adopting negative interest rates for the deposits made there by all the Japanese commercial banks (Mizuho Bank, Bank of Yokohama, SMBC etc). Those deposits will now be CHARGED a 0.1% fee. (Usually commercial banks expect to get a RETURN of a few percent on such deposits).

We do not study this topic in the IB syllabus, but the commercial banks need to keep part of their “cash” reserves at the central bank. They are used to settle payments between banks (eg if Sato-san, who banks with Mizuho, sends Yen 500000 to Kato san, who banks with SMBC) and can also be immediately withdrawn if a bank’s ATMs start to run short of cash. Therefore the Bank of Japan acts as the “bankers’ bank” and also effectively guarantees that it will not let them go bankrupt, even if their customers start to withdraw large amounts of cash.

Therefore the banks will carry on keeping deposits at the Bank of Japan, but they will need to reduce interest rates on their own customers’ deposits in order to maintain their profits and so all interest rates throughtout the economy will tend to come down (even the meagre interest rate on Avkash’s savings, though it probably won’t become negative!).

The aims of this policy are:

  1. ) to encourage banks to lend out more (to reduce their excess cash reserves at the Bank of Japan) and firms to borrow more (because interest rates on loans will be lower). Therefore it is hoped that investment spending will increase. In other words this is a (very) expansionary monetary policy.

It seems to be necessary, because  Japan’s inflation rate was only 0.5% in 2015, way below the BoJ’s 2.0% target and implying that a deflationary spiral is still a risk.  Quantitative easing (effectively “printing money”) is not so easy now because there are fewer government bonds available for the Bank of Japan to buy using newly created money.  Meanwhile,  the government is struggling to convince cautious firms to grant big wage hikes to raise household spending (which has fallen) and drive up prices. Further fiscal expansion cannot be done due to the huge burden of government debt.

2) The second aim is more ulterior. By lowering interest rates throughout the economy, some savers in Japanese banks and financial institutions will decide to withdraw their funds and save overseas leading to an outflow on the Balance of Payments’ financial account–> the yen depreciates.  This raises the risk that there may be a “currency war”, if China responds by devaluing its exchange rate to keep its exports competitive in Japan.







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