Zero lower bound (“ZLB”) is when the short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth.
In a nutshell, it’s when interest rates can’t fall any further below 0%.
If inflation is low and economic growth negative, the central bank will cut interest rates to stimulate demand, in hopes, this will result in higher economic growth.
But if the central bank keeps cutting interest rates, there comes a time when interest rates have fallen to zero and can’t fall any further.
This is the zero lower bound rate (“ZLB”).
At this point, interest rates have fallen as far as they can.
Technically, it is possible to go lower.
A central bank can lower interest rates to negative levels.
But no one would lend money at a negative interest rate. You can just hold cash.
This means the central bank can no longer use interest rates to stimulate the economy.
This scenario is known as a liquidity trap.
In a liquidity trap, increasing the money supply is likely to be ineffective in stimulating economic activity.
Usually, an increase in the money supply leads to lower interest rates and encourages more spending.
But in a liquidity trap, people are generally indifferent to an increase in the money supply. (Usually, because the commercial banks aren’t lending to them so they don’t have access to all this money.)
Interest rates don’t fall and the extra money tends to be saved rather than spent.
In summary, a decrease in interest rates encourages spending, but in a liquidity trap, a change in the money supply does not change spending habits. Therefore, the use of conventional monetary policy is ineffective.
Examples of ZLB
- December 2008: The Federal Reserve (“Fed”) cut interest rates to between 0% and 0.25%. From then on until 2013, the U.S. had been at the ZLB.
- March 2009: The Bank of England (“BoE”) cut interest rates to 0.5% and have stayed there until 2013
- April 2020: Interest rates cut to zero by the Fed, ECB, and BoE in response to the COVID-19 pandemic.