The Zero Lower Bound: The observation that national interest rate never falls below zero because central banks CANNOT set nominal interest rates much below zero

  • This is because it doesn’t make sense; a -5% interest rate would mean that a bank would give you $95 for every $100 you put in
  • According to the Fisher equation, r = i - π, but since i >= 0, r >= -π

The Zero Lower Bound and the MP Curve

  • Because r >= -π, the MP curve is constrained and cannot go below -π, leading to a kink in the curve
  • Oftentimes, this kink doesn’t matter, but there are situations when the Zero Lower Bound is an issue
  • There are other things the government can do aside from changing the nominal interest rate in order to improve economic conditions

Monetary Policy at the Zero Lower Bound

Inflation Expectations

  • The government can use inflation expectations (ex ante vs. ex post real interest rates) to do monetary policy
    • Firms use the ex ante real interest rate to do business
    • The government can use monetary policy to make expected inflation greater than actual inflation (i.e. ex ante < ex post)
    • This means that the MP curve is not as constrained if -π is lower down

Quantitative Easing

  • The central bank can increase the monetary base to try to stimulate the economy (known as quantitative easing)
  • Increasing the monetary base increases prices which increases inflation, thus giving the MP curve more breathing room

Other Methods to Increase Inflation

  • Abandoning the gold standard (dollar was worth less)
  • Increasing government spending

Negative Nominal Interest Rates

  • People can tolerate slightly negative nominal interest rates because the bank storing money for you acts as a service
  • “Paying” for the service of storing money
  • Physical money is inconvenient to store, transport, etc.

How it works:

  • Central bank annoucnes a negative interest rate on electronic reserves
  • Arbitrage pushes other short-term interest rates below zero

Extraordinary Discount Window Lending

  • In a financial crisis, customers want cash but banks don’t have reserves
  • The government gives cash loands to banks so they can give money to customers; known as discount window lending
    • Loans are collaterized so banks can’t weasel their way out
  • Remember that discount loans are seen as a sign of weakness if banks take them, but in a crisis, optics don’t matter as much