Zero Lower Bound
What is Zero Lower Bound?
The zero lower bound is the floor on how far a central bank can cut its policy rate, set by the fact that holding physical cash always pays zero.
Nominal interest rates cannot be pushed far below zero because savers can hold currency instead, and currency pays zero. The true floor sits slightly below zero rather than exactly at it, since storing, insuring and moving large amounts of cash costs something, and a few central banks have set mildly negative policy rates for that reason, which is why economists often say effective lower bound. The bound bites because the real interest rate is roughly the nominal rate minus expected inflation: once the nominal rate is stuck near zero, falling inflation raises the real rate exactly when the economy needs it lower. The bound is not the same thing as a liquidity trap, which is the condition where creating more money stops lowering interest rates at all.
Zero Lower Bound: a worked example
Suppose the policy rate is stuck at 0 percent and expected inflation is 2 percent, so the real rate is 0 minus 2, or negative 2 percent. Now suppose the downturn is deep enough that full employment would require a real rate of negative 4 percent. No rate cut can deliver it, because the nominal rate is already at the floor, so the only route left is raising expected inflation to 4 percent, which gives 0 minus 4, or negative 4 percent. Worse, if the slump instead produces expected deflation of 1 percent, the real rate climbs to 0 minus negative 1, or positive 1 percent. Policy tightens by itself at the worst moment.
The mistake students make with zero lower bound
Students state flatly that interest rates can never be negative, and that hitting zero leaves a central bank powerless. Both are overstatements. Cash is costly to store in bulk, so policy rates have been set slightly below zero in practice, and at the bound a central bank still has asset purchases, forward guidance and the option of raising expected inflation. What it loses is the ordinary tool, not every tool.
Zero Lower Bound questions
Why can't interest rates go far below zero?
Rates cannot fall far below zero because savers can always hold physical cash, which pays zero and cannot be charged a negative rate. In practice the floor sits a little under zero, partly because negative rates tend to be applied to bank reserves rather than to ordinary retail deposits, and partly because moving large sums into physical cash is expensive and awkward.
Is the zero lower bound the same as a liquidity trap?
No, the zero lower bound is a limit on how far the policy rate can be cut, while a liquidity trap is the situation in which extra money creation no longer lowers interest rates or raises spending. They often appear together, and the usual explanation of the trap is that money and short-term bonds have become near-perfect substitutes, so swapping one for the other changes nothing.
What can a central bank do at the zero lower bound?
At the lower bound a central bank can buy longer-term assets, commit to keeping rates low through forward guidance, and try to raise expected inflation, all of which work on long-term rates or on the real rate rather than the overnight rate. Fiscal policy also carries more weight at the bound, because extra government spending is less likely to be offset by a rise in the policy rate.
Formula / Example
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