Zero Lower Bound

Imagine you're asking for a job, and you cannot find one. You ask around local stores, and no one is willing to hire. You find that no one is consuming that much, and the total output in the economy is dropping daily. Everyone around you is losing their jobs and income. The economy is in a recession! To fight the recession, the Fed decided to lower the interest rate to zero, which is also known as the zero lower bound.

This seems like a good solution, but do you think that this might be enough to encourage companies to borrow and invest more so that you can find a job? How would the zero lower bound affect the economy? What would happen if the zero interest rate could not boost the economy?

Read on and find out the answers to these questions and much more!

Zero Lower Bound Meaning

The meaning of zero lower bound refers to an expansionary monetary policy instrument whereby the central bank of a country chooses to lower short-term interest rates to zero in order to boost the economy.

The interest rate in the economy is set by the Federal Reserve (the Fed) or a country's Central bank through monetary policy. The Fed uses monetary policy to adjust the interest rate according to economic developments. In times of inflationary periods, the Fed increases the interest rate. On the other hand, in recessionary periods, the Fed lowers the interest rate.

If this threshold is crossed and the economy continues to perform poorly, the central bank will be unable to provide stimulus in the form of lower interest rates. In economics, this situation is referred to as a liquidity trap.

When an economy is confronted with a liquidity trap, it is often essential to resort to alternate measures for monetary stimulus.

An example of alternative measures that the Fed might resort to when confronted with a liquidity trap includes quantitative easing (QE).

In the aftermath of the 2008 financial crisis, the Fed initiated a series of large-scale asset purchasing programs (quantitative easing). That's because the Fed wasn't able to cut interest rates further.

The Fed started buying long-term government bonds with a maturity date of five years instead of the three-month treasury bills. Additionally, the Fed was buying back mortgage securities from the market.

The long-term government bonds and mortgage backed securities offered higher interest than the short-term interest rate, which was almost zero. Fed chose to apply quantitative easing to drive down the long-term interest rate, which would help the economy recover.

Zero Lower Bound Graph

To understand the zero lower bound graph, let's consider what happens when the central bank of a country decides to pursue a zero lower bound policy.

Zero-lower bound means that the nominal interest rate of a country drops to zero, which is the lowest point it can get.

To understand what happens under such circumstances, we need to have a look at the IS-LM model.

Fig. 1 - Zero lower bound graph

The above graph consists of two main important curves, IS and LM.

On the vertical axis, you have the real interest rate; on the horizontal axis, it is the real output produced in the economy. The intersection of IS and LM curves provides the general equilibrium in the economy.

When the economy is in a recession, the central bank can decide to increase the money supply by decreasing the interest rate to zero. Consequently, there is more money circulating in the economy. As a result, this shifts the LM curve to the right. The new equilibrium occurs at the higher level of economic output and the lower real interest rate. Economic production grows because the real cost of borrowing drops, and it provides the incentive for people in the economy to increase their spending.

Effective Lower Bound and Zero Lower Bound

To understand effective lower bound and zero lower bound, let's start by discussing the concept of effective lower bound.

The effective lower bound, often known as ELB, is a phrase that pertains to how a country's central bank manages the nation's monetary policy.

Zero lower bound is the minimum point to which the interest rate can be lowered. The effective lower bound shows the minimum interest rate, which is still capable of having an impact on the economy.

During the 2008 financial crisis, the Taylor rule suggested that the economic interest rate should be negative to boost the economy. However, the Fed did not lower the interest rate below zero as it was constrained by the zero lower bound.

Zero Lower Bound Inflation

What is the zero lower bound on inflation? The issue with the nominal interest rates that are equal to zero is that the resulting real interest rates may be unacceptably high.

It is also possible that committing to greater inflation would enhance higher growth expectations, which will promote spending because of the anticipation of higher growth. The risk of committing to greater inflation is that inflationary expectations may get entrenched, and higher inflation may generate uncertainty, which inhibits investment.

Zero Lower Bound Fiscal Policy

Zero lower bound and fiscal policy are often used when the zero interest rate is incapable of boosting the economy.

To boost economic growth, the government can either choose to increase its spending levels or reduce taxation.

The fiscal policy provides a direct infusion of spending into the economy when the federal funds rate is at the zero lower bound. The injection of spending by the government is capable of increasing demand, which in turn affects economic output. Additionally, as a result of the increase in demand and spending, the surplus of savings is also added to the economy. Thus, the use of expansionary fiscal policy may play an important role in boosting the economy, especially if the fiscal multiplier is high.

In addition, when the zero lower bound is reached, bond yields are anticipated to be relatively low, and the government will have an easier time borrowing money at reasonable rates.

If monetary policy is inefficient, then the use of fiscal policy to ensure that there is a boost in demand is vital. One of the consequences of employing budgetary policy is the increase in the amount of debt incurred by the government.