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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.

To revive the economy, the central bank that is compelled to implement this policy is required to additionally explore other means of stimulation, many of which are not traditional.

**Zero lower bound** is the idea that the nominal interest rate can't fall below zero without causing economic problems.

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.

There are apparent restrictions, most notably at the lower end of the spectrum.

To what extent can a country's central bank lower the interest rate? That point would be zero.

The **zero bound** occurs when the interest rate in the economy is at zero.

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**.

A** liquidity trap** is a paradoxical economic condition in which interest rates are extremely low, and savings rates are high, leaving monetary policy ineffective.

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)**.

**Quantitative easing** is a type of monetary policy which involves buying securities from the open market to inject money into the economy.

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**.

We have an explanation on the IS-LM model. Feel free to check it out!

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

The **IS curve** depicts multiple equilibria in the **goods market** (total saving equals total investment)at various real interest rates and real output combinations.

The **LM curve** depicts multiple equilibria in the **asset market** (money supplied equals money demanded)at various real interest rates and real output combinations.

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.

The term **effective lower bound** (ELB) refers to the point at which additional reductions in the interest rate of monetary policy no longer offer a boost to aggregate demand and GDP.

In many countries over the past few years, and especially in the years following the Global Financial Crisis of 2007-2008, the policy interest rate has been set at a level that is significantly lower than the equilibrium interest rate to provide support for demand, output, and jobs while also reducing the risks of deflation.

Some countries' central banks, such as those in Denmark, Sweden, and Switzerland, have implemented negative interest rates by lowering their policy interest rates below zero, also known as a **shift to negative interest rates**.

**Negative interest rate impact on demand**

The most recent research conducted by the Bank of England in the United Kingdom indicates that negative interest rates would not effectively stimulate demand during a recession. As a result, the Bank of England prefers to keep its monetary policy interest rate at a positive level (0.1%) but only slightly above zero.^{1}

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.

The** Taylor rule** is a monetary policy rule that sets the interest rate according to the economic output and price level.

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.

Don't forget to have a look at our detailed explanation of the Taylor rule!

## 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.

The **real interest rate** is the difference between the nominal interest rate and the inflation rate.

If nominal interest rates are at 0% and inflation is running at 1%, then real interest rates are at -1%. If the government sets a goal of more significant inflation and successfully achieves that goal, real interest rates will decline, offering an incentive to borrow money and spend it.

If the government successfully achieved an inflation rate of 4%, real interest rates would decrease to -4%. Keeping cash on hand when inflation is running at 4% and interest rates are at 0% implies that the value of your money is decreasing. As a result, there is a stronger motivation to make expenditures.

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.

**Fiscal policy** refers to the use of taxes or government expenditure in order to influence 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.

If you'd like to find out more about the Fiscal Multiplier, check out our article!

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.

## Zero Lower Bound - Key takeaways

**Zero lower bound**is the idea that the nominal interest rate can't fall below zero without causing economic problems.- The term
**effective lower bound**(ELB) refers to the point at which additional reductions in the interest rate of monetary policy no longer offer a boost to aggregate demand and GDP. - A
**liquidity trap**is a paradoxical economic condition in which interest rates are extremely low, and savings rates are high, leaving monetary policy ineffective. - The risk of committing to greater inflation is that
**inflationary expectations**may get**entrenched**, and higher inflation may generate**uncertainty**, which inhibits investment.

## References

- Bank of England, What are negative interest rates, and how would they affect me? https://www.bankofengland.co.uk/knowledgebank/what-are-negative-interest-rates

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##### Frequently Asked Questions about Zero Lower Bound

Why is Zero Lower Bound a problem?

Zero lower bound could become a problem at the point when the zero interest rate can't boost the economy.

What is meant by zero lower bound?

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

Why is monetary policy ineffective at the zero lower bound?

Monetary policy becomes ineffective when the economy enters a liquidity trap. A liquidity trap is a paradoxical economic condition in which interest rates are extremely low and savings rates are high, leaving monetary policy ineffective.

How does the zero lower bound work?

The zero lower bound works by having the nominal interest rate in the economy very close to zero.

How do you fix a zero lower bound?

The zero lower bound is fixed by the use of monetary policy tools.

When the zero-lower-bound problem occurs central banks can rely on?

When the zero-lower-bound problem occurs central banks can rely on quantitative easing.

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