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The European Central Bank (ECB) has been lowering the interest rate on its deposit facility, first to -0.1% in June 2014, then to -0.2% in September and eventually to -0.3% in December 2015.

But what difference does it make whether it is -0.1% or -0.3%, as long as it is negative? I would expect anyone to withdraw all their money immediately as soon as the interest rate gets negative, for you would always be better off just keeping it for yourself, even if the interest rate is just -0.0001%.

I do understand the intention of the ECB, but I do not understand why lowering the already negative interest rate further should make it more effective.

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2 Answers 2

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You are assuming that the supply of deposits is zero when the price (the rate) is zero but it definitely is not. There are several reasons for this.

  1. While you can withdraw cash from the bank it is unwieldy, costly, and unsafe to have large amounts of cash lying around. Therefore, if there were no other alternatives, heavy spenders would still want some wealth in deposit system even if rates were quite negative. Consider, for example, that it is common for depositors to pay account fees that greatly exceed interest earnings.
  2. These costs are actually very low as it goes. A rate of -0.1 percent a year is ten cents per \$100 of average balance, and since these costs are proportional to average balances, which themselves are small relative to total spending, the value of transaction services provided by these accounts is probably large relative to total negative interest rate costs.
  3. Assuming non-bank storage costs are high relative to negative rates, it isn't the nominal negative rates (the advertised rate) that matters but rather the real rates (relative to inflation). Under these circumstances, you should be indifferent between 2 percent deposit rates under 4 percent inflation and -1 percent deposit rates under 1 percent inflation. So a rate can drop and the supply of funds can be unchanged if it is accompanied by a drop in inflation.

And, in the case of the EMU / ECB / Euro, that may well be what happened. Inflation fell for the five months after June 2014, which may explain why nominal rates had to fall: to keep the tightness of monetary policy unchanged or at least to keep real rates unchanged.

Harmonized Index of Consumer Prices: All Items for Euro area (17 countries) 2014-2015

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  • $\begingroup$ Thanks! So basically the reason why this works is because storage itself costs money and is risky? And my error was to assume that this costs are zero or negligible? $\endgroup$
    – proskor
    Jan 28, 2016 at 13:57
  • $\begingroup$ That's my understanding. If you could safely and at no cost hold even huge amounts of cash it would be difficult or impossible to sustain negative nominal rates. $\endgroup$
    – BKay
    Jan 28, 2016 at 14:03
  • $\begingroup$ Small nitpick: 2 percent interest with 4 percent inflation gives a real change of 1.02*0.96=0.9792, while -1 percent interest with 1 percent inflation gives a real change of 0.99*0.99=0.9801. So it is not exactly equal. $\endgroup$
    – wythagoras
    Jan 28, 2016 at 17:47
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    $\begingroup$ Yes of course, you are correct. I was using the $r + i \approx (1+r) (1+i) -1 $ approximation. $\endgroup$
    – BKay
    Jan 28, 2016 at 17:53
  • $\begingroup$ It's can also be quite difficult for people to pay at least some of bills without that money being in a bank account at some point. $\endgroup$
    – Michael
    Jul 11, 2022 at 20:26
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Firstly this is the rates that banks get/pay for depositing with the ECB. It is not directly related to the rate that a consumer pays for depositing with a bank.

Now you may ask, why does any bank deposit with the ECB in that case? The trick is that that's how the central banking system is set up. Every bank has their accounts with the ECB. Not only that but any excess liquidity the bank has -- anything above the minimum reserve requirement -- is treated as if it were a deposit. So the bank gets penalized -0.5% for any money they have extra than is strictly necessary to meet the reserve.

In short they "deposit" with the ECB because they are forced to :D . In that case you will be able to see how further lowering the rate leads to a higher penalty and therefore continues to affect behavior.

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