On the negatives of negative interest rates

Abstract

Major European central banks and the Bank of Japan have remunerated reserves at negative rates (NIR) for almost a decade, justifying a theoretical study on the long-run effects of NIR. We do so through the lens of a dynamic general equilibrium model with commercial banks that fund investments by creating retail deposits, which must be backed by reserves. Because depositors can use zero-interest cash as an alternative store of value, the effect of permanent rate cuts qualitatively changes once in NIR territory. Particularly, rate cuts reduce welfare, investment, output, and bank profit, and increase the nominal price level. These effects are attenuated once in NIR territory due to a lack of transmission to depositors. NIR does, however, give rise to an overinvestment distortion.