By Ethan Wolff-Mann
January 29, 2016
Haruhiko Kuroda, governor of the Bank of Japan
Akio Kon—Bloomberg via Getty Images

Japan’s central bank just set interest rates below zero for the first time ever, in an attempt to plug its leaking economy. It’s a bold strategy that the Wall Street Journal called “desperate.”

The Bank of Japan’s governor had previously said he wouldn’t resort to this tactic. Yet the bank’s worries that the country’s economy could be brought down further by the global slump evidently changed his mind.

But what does a negative interest rate mean for a central bank in the first place?

In a nutshell, central banks allow financial institutions to borrow money overnight from one another to make sure they have enough cash in reserve. A bank that has extra cash at the Fed (in a U.S. example) can lend it to another bank that’s short of its cash reserve requirements and earn the Fed’s interest rate.

When these rates are high, banks are disincentivized from borrowing from each other. This chills the economy because less borrowing between banks means less money passed on to the borrowing public, and higher interest rates apply to whatever borrowing is taking place.

On the flip side, when interest rates are low, banks get interested in borrowing more, and the public, in turn, borrows more from the banks. This stimulates the economy.

However, this hasn’t worked well for Japan’s central bank. Low interest rates haven’t done much to help, nor has quantitative easing, which the Bank of Japan has done by buying up tons of bonds and other debt, pumping money into the economy. But the economy didn’t improve much.

So the bank pushed the rates below zero. Now, a financial institution that has a surplus of money in Japan’s central bank earns negative interest. In other words, the bank has to pay a fee to park its cash reserves there. In theory, this means it’s expensive for a bank to sit on its money. Therefore, banks are more likely to go out and lend that money to someone else—companies, most obviously. Putting that money into companies, and the general public, is supposed to reinvigorate the economy.

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