Zero Lower Bound

Updated on April 9, 2024
Article byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Zero Lower Bound (ZLB)?

Zero Lower Bounds refer to the central bank reducing the short-term interest rates to zero or near zero. It is believed that the interest rates in an economy cannot go below zero. The short-term interest rate reduction is initiated by a country’s central bank to give the economy the required momentum to grow.

Zero Lower Bound

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Zero Lower Bound is a measure adopted to combat a recession or financial crisis. However, when such situations arise, even zero interest rates might not help. Hence, central banks must adopt unconventional methods to revive the economy. As recession is considered a macroeconomic problem, banks reduce their short-term interest rates to boost investments. Countries also use it as a control measure during periods of rapid growth, called a boom.

Key Takeaways

  • Zero lower bounds are used when a nation’s central bank wishes to regulate interest rates as a monetary policy measure to support the economy in times of crisis.
  • The 2008 Financial Crisis and The Great Recession forced many governments to adopt the zero lower bound to regain investor confidence in their economies.
  • It is also called the Zero Nominal Lower Bound, which causes a liquidity trap for many countries, resulting in a situation where interest rates cannot fall below zero.
  • With time, the economy may grow, but the zero lower bound technique is often seen as an aggressive method taken in crisis to propel the economy towards growth forcefully.

Zero Lower Bound Explained

Zero Lower Bounds, a monetary policy tool, is adopted to tackle an economic crisis or address issues in a collapsing economy. Under this method, the central banks of the respective country reduce the short-term interest rates to zero or near zero. It fuels the economy but cannot fully revive it, even after the interest rates are lowered to zero.

The zero lower bound monetary policy is one of the unconventional methods governments adopt during recessionary times and financial crises. It was adopted during the 2008 US Financial Crisis that disturbed the world economy. Many countries, along with the US Federal Reserve, had decreased their interest rates to zero.

The zero lower bound definition states that reducing the interest rates below zero is impractical, and there is no guarantee that it will prompt economic growth. This is because there is no point in lending money at zero or negative interest rates. On the contrary, it seems wise to hold on to cash in such times. This situation is called a liquidity trap. The common belief is that reduced interest rates entice people to invest or spend more, increasing public spending in the market. However, typically, people do not invest or spend as expected. This makes the strategy almost ineffective.

Causes

The Zero Lower Bound strategy is a non-traditional mechanism to correct significant upward or downward movements in an economy. The main causes are:

  • When an economy goes through a financial crisis, the market has low cash flow movement.
  • When a country undergoes a recession, there are no vacancies. Businesses do not announce any new projects either. Due to the general economic gloom, people save more and spend less.
  • Natural calamities, including wars, floods, and disrupted socio-economic and political conditions, force people to retain their savings for a long time.
  • The banking system fails as people lose confidence in it, and fewer investments are initiated.

How To Deal With It?

A few steps countries that can help overcome and deal with zero lower bound problems are as follows:

  • Negative real interest rates: Many economists believe that the zero lower bound method is only theoretically possible; it is not a practical solution. Still, it is often considered an option in turbulent economic conditions.
  • Fiscal policy: It induces a direct economic demand, bringing steady economic growth through surplus savings. If the monetary policy fails, the fiscal policy is most likely to stimulate the demand. In a ZLB situation, the bond rates are low, making it easier for governments to borrow. However, at the same time, it is also treated as a hurdle while implementing the fiscal policy.
  • High inflation: When the inflation rate is high, the real interest rates decline, creating an incentive for borrowing and spending. With a high inflation rate when interest rates are near zero, retaining liquid cash indicates a decline in the value of savings. As a result, spending becomes a better incentive. Additionally, deflation is a more prominent factor limiting economic growth.

Examples

Here are a few examples that explain the ZLB strategy in specific situations.

Example #1

Imagine a flood destroyed a city, and a war is underway in the neighboring regions. The city’s economy is declining, and new and old businesses are shutting down. There are no jobs available. The market has no resources, and people are living off their savings. People are forced to work on minimum wages because there are no new projects. No new investment is being infused in the capital markets. People withdraw their funds, and no new loans are being taken.

In such recessionary periods, the central bank executes the zero lower bounds strategy and lowers the short-term interest rates to zero or near zero to encourage people to apply for loans. This is a simple example of zero lower bound economics. Banks endeavor to encourage people to take financial action. Initially, it seems like a good solution, but considering real-world probabilities, it is not enough to stabilize the economy.

Example #2

According to a report published by the International Monetary Fund, there is no escape for top central banks from zero lower bound problems. As per analysts at the IMF, the interest rates are currently high because central banks are dealing with inflation. However, once the situation is under control, central banks are most likely to bring real interest rates back to pre-COVID-19 pandemic levels.

They also believe the natural interest rate will remain low in advanced economies and decrease in emerging markets. If this happens, governments can borrow at cheap rates. But developed countries will still need to depend on bond buying and other conventional strategies. It has also been speculated that once the rates are normalized, a grave recession may force central banks to undo the changes brought about by globalization.

Graph

Let us look at a graph to understand the concept better:

Source

The above graph explains how zero lower bounds form a liquidity trap. The dark black line represents the actual federal funds rate, and the line below indicates the Taylor Rule. The Taylor Rule shows the relation between inflation and the economic growth of a country. The above graph depicts the 2008 financial crisis. It reflects the unconventional monetary policy adopted by the US government during that period.

Zero Lower Bound vs Effective Lower Bound

Let us study the difference between Zero Lower Bound and Effective Lower Bound to understand how these measures are used by a country’s government.

  • ZLB is a monetary policy measure to bring the real interest rates to zero or near zero. The Effective Lower Bound is an offshoot of ZLB that says short-term interest rates should not be reduced below zero because they do not help achieve the required objective after a certain point. It means they work only up to a certain point.
  • The zero lower bound interest rates can be zero or anywhere close to it on the positive side. In contrast, the effective lower bound would rather be negative than zero as it accounts for the security and storage costs of holding physical cash.
  • Banks employ ZLB to attract investments in times of recession. On the contrary, an effective lower bound is the rate that enables banks to exchange central bank reserves for cash.

Frequently Asked Questions (FAQs)

1. What are the consequences of zero lower bound?

The consequences of zero lower bound are:
· People lose confidence in the economy.
· Banks are not allowed to implement traditional monetary policies.
· The possibility of conditions not improving, even after the ZLB technique is applied, remains.
· Banks depend on unconventional methods to give the economy an impetus.

2. What is the Taylor Rule at ZLB?

The Taylor Rule is a system to determine interest rates in the economy based on varying economic conditions. At ZLB, it assumes nominal interest rates to be fixed at zero till the exit date.

3. Why should the zero lower bound interest rates not go below zero?

ZLB is more of a theoretical concept. The real interest rates cannot fall below zero, making ZLB impractical. It usually induces a liquidity trap in the market. People are more interested in holding on to their savings. They will likely not spend.

This has been a guide to What is Zero Lower Bound. We explain its examples, comparison with effective lower bound, causes, graph, and how to deal with it. You can learn more about it from the following articles –

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