Zero Lower Bound
ZLB is the idea that interest rates can’t fall below 0%.
What Is Zero-Bound?
Zero lower bound (ZLB) is the idea that interest rates can’t fall below 0%. As a result, central banks cannot use monetary policy effectively to stimulate the economy.
Besides government intervention, central banks can also have a crucial role in stimulating the economy. It does so by implementing an expansionary monetary policy.
In summary, the expansionary monetary policy requires the central bank to increase the money supply in the economy. There are multiple methods to boost the money supply. Some of them include:
1. Decreasing vault money
The amount of money required by banks to keep in their vaults is decreased (also known as reducing the required reserve ratio). This way, the banks have more opportunities to create money by lending it to households and firms.
2. Conducting open market operations
To increase the money supply, the central bank conducts open market purchases, in which it buys government bonds and injects money into the economy. To decrease the money supply, it sells government bonds and collects money from the economy.
After increasing the money supply, the economy is expected to gain more traction. That is because interest would decrease after an increase in the money supply. This will increase investment and consumption, hence boosting the economy.
However, once interest rates are so low - characterizing the ZLB - increasing money supply, monetary policy will be ineffective.
Key Takeaways
- Zero Lower Bound (ZLB) refers to the point at which interest rates cannot fall below zero percent. At this stage, conventional monetary policies become ineffective, hindering the central bank's ability to stimulate the economy.
- ZLB often leads to liquidity traps, where interest rates are so low that holding cash becomes as attractive as investing.
- Economies can overcome ZLB through policies like inducing higher inflation rates, employing fiscal policies, and implementing negative interest rates to incentivize spending and investment.
Zero Lower Bound and Liquidity Traps
Close to zero interest rates characterize ZLB. This macroeconomic problem is known to cause liquidity traps. Liquidity traps are when interest rates become so low that the central bank can no longer stimulate the economy during a slowdown or a recession.
American Economist Paul Krugman defined liquidity traps and the zero lower bound by the following:
“A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent because nominal interest rates are at or near zero rates, creating the zero lower bound.”
He continued, “injecting the monetary base in the economy has no effect since the monetary base and bonds are viewed by the private sector as perfect substitutes.”
What did he mean by perfect substitutes? Because interest rates are almost zero percent, bonds have an interest near zero. In the meantime, cash also has a zero return. Therefore, one would be indifferent between holding bonds versus holding cash.
If the central banks can’t reduce interest rates any further, monetary policy will be useless for them in trying to save the economy. Hence, they will resort to other non-mainstream policies to reverse recessions and promote growth.
Money Market And Monetary Policy
Discussing monetary policy always refers to the money market in the economy. The money market graph is composed of the demand and supply of money.
The demand for money shows the people’s liquidity preference. The supply of money is regarded as exogenously fixed and set by the central bank.
The two main components of the money market:
1. Money demand is negatively related to the interest rate.
People can either keep their money as cash or buy interest-bearing assets like bonds. The higher the interest rate, the more people would like to hold bonds and less cash, hence the negative relation.
2. Vertical money supply
It is verticle since decided by the central bank. The money demand and money supply together determine the nominal interest rate.
Now we turn to how monetary policy affects the interest rate in the money market. When the Fed increases the money supply, this decreases interest rates.
This decrease in the nominal interest rate stimulates the economy because lower interest rates encourage investment and consumer spending.
Challenges of the Zero Lower Bound
Now our question becomes: what happens if the interest falls very close to zero? This essentially creates the ZLB, and the economy falls into a liquidity trap. People reach a certain point where they prefer to hold all their assets in liquid cash.
Why is this a problem?
When a country faces a recession, the government has two main options to stimulate the economy manually:
1. Expansionary fiscal policy
Increasing government spending and reducing taxes to increase aggregate income.
2. Expansionary monetary policy
Increasing the money supply to decrease the interest rate triggers consumer spending and investment.
However, the zero lower bound effectively removes expansionary monetary policy as one of the main options to activate the economy.
That is because the interest rates are already very low, so increasing the money supply will virtually have no role in bringing the economy out of a recession. The extra money in the economy is saved instead of being spent on consumption.
Causes of Liquidity Traps
As discussed, banks can’t decrease interest rates to jumpstart the economy because the rates are already very low. This phenomenon is called a liquidity trap.
The most common causes of such liquidity traps are:
1. No desire to purchase bonds
When interest rates are close to zero, bondholders no longer want to invest their money by buying bonds. They would rather hold all their assets in cash. That is because they expect rates to rise in the future, which will cause bond prices to rise.
2. Low price levels (deflation)
Very low-interest rates, coupled with negative inflation rates, automatically increase the real interest rate. With deflation, stashing cash is more beneficial as its value will increase.
3. Inelastic demand for investment
Generally, firms intend to invest more when interest rates are low. However, companies are unwilling to invest in recessions in a ZLB situation. The low levels of aggregate demand in the economy make investments unattractive for firms though the cost of borrowing is low.
4. Saving rather than spending
During economic downturns, firms and households are more cautious, saving a larger portion of their incomes and revenues. This pessimism decreases consumer spending levels and further intensifies the liquidity trap.
5. Decreased borrowing because of recession
Sluggish economies in a recession generally create the need for consumers and companies to pay off their debt. This behavior depresses spending because the agents in the economy are more concerned with paying off their debt.
Overcoming the Zero Lower Bound
An economy can overcome the ZLB by:
1. Inducing Higher Inflation Rates
The main objective is to increase spending and income in the aggregate economy to pull it out of a recession. At the ZLB, where interest rates are close to zero, the real interest rates on assets such as bonds tend to be high when deflation occurs.
Therefore, if the real interest rate decreases, people would be more willing to invest and spend their money.
The most practical means to achieve this is by inducing higher positive inflation levels. This way, the real interest rate declines, encouraging consumers to spend their saved money on goods and services.
Recall Fisher’s Equation, which establishes a relation between the nominal interest rate, real interest rate, and the rate of inflation.
It states that the real interest rate is approximately equal to the nominal interest rate minus the inflation rate.
r = i - π
Where,
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r is the real interest rate,
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i is the nominal interest rate,
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and π is the rate of inflation.
According to this equation, an increase in the inflation rate will reduce the real interest rate, especially at the zero lower bound.
For example, suppose an economy in recession is at the ZLB rate. The recession has caused deflation at a rate of 3%. According to the Fisher Equation, the real interest rate should be:
r = i - π = 0 - (-3) = 3%
As discussed, it is suitable to decrease the real interest rates, in this case, to boost consumer spending and revive the economy. That is achieved by targeting a certain inflation rate. For example, say the government targets an inflation rate of 1%, the real interest rate would be -1%.
For example, if the government wants to reduce the real interest rate further (maybe because the recession is more severe than usual), it targets a higher inflation rate of 3%. In this way, a large incentive to borrow and spend will be created.
Another advantage of this strategy is that higher rates of inflation are also likely to raise economic expectations, which will boost expenditure by households and firms.
However, there is also a possible downside to this approach. Targeting slightly higher inflation rates will increase expected future inflation among the agents of the economy.
Sometimes, inflationary expectations become embedded. This psychology produces uncertainty in the economy, which may be the opposite of the desired effect.
2. Fiscal Policy
As discussed at the beginning of this article, monetary policy is ineffective at the zero lower bound. Increasing the money supply won’t bring an economy out of recession. Of the two main macroeconomic policies, only fiscal policy proves to be effective in reviving the economy.
Fiscal policy includes increasing government spending or decreasing taxes. Increasing government spending directly increases aggregate demand in the economy.
This increase in demand will have a multiplier effect on economic performance, as all the saved money will start getting spent, and the economy will start growing.
Bond yields are generally low at the lower zero bound because of the low-interest rates. This makes it cheaper for the government to buy bonds and borrow money to implement fiscal policy. However, the downside to this is that it greatly increases public debt.
One more uncommon and controversial policy that monetary authorities can adopt is charging negative interest rates. This essentially breaks the lower zero bound. As a depositor, you would have to pay money instead of receiving money on your deposits.
Charging negative interest rates has three main purposes:
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Encourage banks to lend out more of their deposits
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Incentivize households and companies to invest and spend their money instead of hoarding it
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Increase aggregate demand in the economy
The Zero Lower Bound and the 2008 Recession
Following the Keynesian economic model, most central banks utilize monetary policy to control interest rates in the economy.
However, decreasing interest rates during major recessions may not help stimulate the economy. That is because interest rates are already low and close to zero percent.
Unorthodox measures and uncommon policies were used to help the economy escape the liquidity trap during the 2008-2009 financial crisis.
Upon the start of the recession in early 2008, the major central banks of the world, including the European Central Bank, the Bank of England, and the US Federal Reserve - started lowering their interest rates.
However, they eventually reached the ZLB by 2009. For example, the bank rate in England decreased from 5% to 0.5%.
Since they couldn’t lower interest rates anymore to save the economy, they were forced to adopt other unconventional policies, the most important of which was quantitative easing.
What Is Quantitative Easing?
When the government buys bonds to cut interest rates on savings and loans, this is known as quantitative easing.
Quantitative easing starts with the central bank buying government or corporate bonds. This will drive up the price of those bonds. As a result of the price increase, the yield of those bonds (essentially the interest rate) will decrease.
As a result, the decrease in government and corporate bond interest rates will lead to a decrease in the interest rate of household and business loans. Eventually, boosting spending and bringing the economy out of recession.
Another way that quantitative easing stimulates the economy is by affecting the prices of assets like stocks and real estate.
Suppose the central bank buys a hefty amount of bonds from a pension fund. The pension fund puts that cash to work by investing it in assets of higher return like shares.
This action will increase the prices of those shares, making their owners (households and businesses) wealthier and increasing their spending.
Since 2008, the Fed has done over $4.5 trillion of quantitative easing. The Bank of England has done $940 billion of quantitative easing.
Implementing Negative Interest Rates
After the 2008-2009 recession, some countries also tried another alternative, which is charging negative interest rates. Central banks decrease interest rates to stimulate the economy, and eventually, some of them break out of the ZLB rate to further boost recovery.
When the interest rate is negative, you get the interest for borrowing money from the bank instead of paying interest. This greatly encourages households and businesses to start spending during economic downturns.
Countries that currently have negative interest rates:
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Switzerland (-0.25%)
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Denmark (-0.60%)
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Japan (-0.10%)
Sweden was the first country to implement negative interest rates in 2009, after which the European Central Bank, Bank of Japan, and other major central banks followed suit.
Switzerland, for example, had a unique purpose for its negative interest rates. The Swiss National Banks (SNB) aimed at preventing the country’s currency from being overvalued, so they cut down interest rates and even broke the zero lower bound.
Higher interest rates drive the value of that country’s currency. That is because higher interest rates attract capital into that country, increasing the demand for that country’s currency.
Why did Switzerland aim to suppress its currency?
Because when the Swiss Franc goes up in value, that significantly damages the export industry. Swiss goods would be more expensive to other countries, so other countries would stop buying Swiss goods.
SNB keeps interest rates below the zero lower bound to protect the export industry partly. It will keep on doing so until it becomes possible to slightly raise interest rates above zero without causing a large appreciation of the currency.
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