Economics
Zero Lower Bound
The Zero Lower Bound refers to the lowest possible level that nominal interest rates can reach, typically zero percent. When interest rates hit this lower bound, central banks may face limitations in stimulating the economy through conventional monetary policy. This can lead to challenges in managing deflation and promoting economic growth.
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9 Key excerpts on "Zero Lower Bound"
eBook - ePubCentral Banking after the Great Recession
Lessons Learned, Challenges Ahead
- David Wessel(Author)
- 2014(Publication Date)
- Brookings Institution Press(Publisher)
3
MONETARY POLICY WHEN RATES HIT ZEROPutting Theory into Practice
JOHN C. WILLIAMSIt has been said, “An economist is a man who, when he finds something works in practice, wonders if it works in theory.”1 The study of the Zero Lower Bound (ZLB) on nominal interest rates is an example of precisely the opposite: economists first figuring out what works in theory and then seeing if it works in practice. Japan's experience with price deflation and zero short-term interest rates beginning in the 1990s led to a flurry of economic research on the ZLB and its implications for monetary policy (see, for example, Benhabib, Schmitt-Grohé, and Uribe 2001; Eggertsson and Woodford 2003; Reifschneider and Williams 2000; and references therein). This research came to a number of concrete conclusions and policy prescriptions that influenced policymaking during and after the global financial crisis.One conclusion from the precrisis research was that the ZLB was a problem that could potentially afflict any economy with a sufficiently low inflation target, but that the episodes at the ZLB would be relatively infrequent and generally short-lived. For example, Reifschneider and Williams (2000) found that under a standard Taylor (1993) monetary policy rule and a 2 percent inflation target, monetary policy would be constrained at the ZLB about 5 percent of the time, and ZLB episodes would typically last just one year. Other research came to even more sanguine conclusions regarding the likely effects of the ZLB, in part because that research was often predicated on an economic environment similar to the tranquil Great Moderation period of the 1980s and 1990s in the United States (see, for example, Adam and Billi 2006; Coenen, Orphanides, and Wieland 2004; Schmitt-Grohé and Uribe 2007).Second, this research identified monetary policy strategies that should be effective at reducing most of the adverse effects of the ZLB. Specifically, short-term rates should be cut aggressively when deflation or a severe downturn threatens (Reifschneider and Williams 2000, 2002). That is, do not
eBook - ePubNegative Interest Rates and Financial Stability
Lessons in Systemic Risk
- Karol Rogowicz, Małgorzata Iwanicz-Drozdowska(Authors)
- 2022(Publication Date)
- Routledge(Publisher)
Consequently, also the role of lower bound for nominal interest rate is of little importance so long as the central bank may affect the level of expected rates and inflationary expectations, hence the expected real interest rates. Much as perfectly applicable for cash-free economy, this assumption changes along with the change of the relative importance of cash. It is because the alternative cost of holding money in cash is closely related to the real rate of return on any chosen investment and the real rate of return on cash. With zero cost of holding cash, the difference between those two equals the nominal interest rate level (Kimball, 2015). The topic is all the more important that the economy reaching the lower bound for interest rates considerably increases the risk of deflationary trap (i.e., a situation whereby the expected macroeconomic situation requires further easing of monetary policy, yet the nominal interest rates must not be employed by the central bank for this purpose; Brzoza-Brzezina et al., 2016). Depending on its determinants, the very level of the lower bound for interest rates may, however, be defined in several ways: on the one hand as Zero Lower Bound and as technical or economic bound on the other. 2.3.1 Zero Lower Bound The theory of Zero Lower Bound is common in the literature. The Zero Lower Bound (ZLB) is considered to be a major – next to downward nominal wage rigidity – phenomenon determining the efficiency of monetary policy with low inflation and deflation, and it is also an important argument in favour of non-zero inflation (IMF, 1999). ZLB risk materialization poses a threat whenever – with adequately strong deflationary shock causing a fall in the general price level and persistent deflationary expectations emerging – the economy may fall into a liquidity trap (Svensson, 2000)
No longer available |Learn more- Janice Eberly, James H. Stock(Authors)
- 2017(Publication Date)
- Brookings Institution Press(Publisher)
Emi Nakamura followed up on comments made by Kocherlakota and reiterated by Blinder about there being an issue with the government pro-viding a store of value in the form of currency, which earns no interest. In her view, the issue with the Zero Lower Bound has more to do with the fact that cash is a unit of account rather than a store of value. Her intuition about the problem of the Zero Lower Bound is that shocks in the economy cause the real interest rate to fall, but often prices do not respond. If nominal interest 7. Michael T. Kiley, “Aggregate Demand Effects of Short- and Long-Term Interest Rates,” International Journal of Central Banking 10, no. 4 (2014): 69–104. COMMENTS and DISCUSSION 395 rates are fixed at zero, then in the face of a recessionary shock, according to the real business cycle model, prices should jump down instantaneously, then start to rise. The subsequent rise leads to a reduction in the real inter-est rate. But if prices do not jump, she noted, what seems to happen is that inflation is low and real interest rates actually rise, which is the opposite of what is supposed to happen in the real business cycle model. Therefore, the fundamental issue is that the unit of account—the price level—does not jump, she concluded. Eric Swanson noted that just touching the Zero Lower Bound is not really a problem in the authors’ models; in order to have any important effects, the Zero Lower Bound must constrain the short-term interest rate for sev-eral quarters. For example, Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo find that the Zero Lower Bound needs to bind for about eight quarters or more to have any significant effect on their model. 8 Kiley and Roberts find that the Zero Lower Bound binds about 40 percent of the time; Swanson posited that a much more relevant statistic would be how often the Zero Lower Bound binds for, say, eight quarters or more.
eBook - ePub- Livio Stracca(Author)
- 2018(Publication Date)
- Routledge(Publisher)
10 Moreover, central banks are ultimately responsible for the management of aggregate demand in the economy, and cannot think of always being ‘bailed out’ at the ZLB by the fiscal authority. Therefore, central banks have to find their own way out of the ZLB.Five ways out of the ZLB
By now it should be clear that the zero bound is a significant problem for monetary policy. What a monetary policy would want to do is to run a policy that overcomes the zero bound, i.e. set aggregate demand at a level that would result from a negative interest rate, even if that cannot be obtained. The common idea is to set policy so that its effects are the same as those which would prevail if the nominal short-term interest rate would be allowed to be negative. In fact, the effectiveness of these measures is often gauged by some kind of ‘shadow’ interest rate, i.e. the interest rate below zero that truly corresponds to the current stance of policy and that the zero-bounded interest rate cannot properly measure. Figure 4.1 reports one of such measures for the United States, and at the same time illustrates just how widespread the ZLB problem is in advanced countries.FIGURE 4.1 Short-term interest rates in the world’s major industrialised economies. The Wu-Xia ‘shadow’ federal funds rate is an indicator of the interest rate that takes into account the effect of non-standard measures such as QE.In the rest of this chapter, we are going to see four of five possible ways to circumvent the zero bound. It is important to note from the outset that none of them is still a fool-proof way to overcome the ZLB. Economists are divided on whether any of these method are really effective, and it is fair to say that the profession is still rather divided on whether there is any practical solution at all for the ZLB problem.
eBook - ePub- John H. Cochrane, John B. Taylor, John H. Cochrane, John B. Taylor(Authors)
- 2020(Publication Date)
- Hoover Institution Press(Publisher)
– 67.- Mendes, Rhys R. 2011. “Uncertainty and the Zero Lower Bound: A Theoretical Analysis.” Bank of Canada.
- Mertens, Thomas M., and John C. Williams. 2018. “What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices.” Federal Reserve Bank of San Francisco, Working Paper 2018-03, August.
- ________ . 2019. “Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates.” American Economic Review, Papers and Proceedings 109 (May): 427– 32.
- Nakata, Taisuke, and Sebastian Schmidt. 2019. “Gradualism and Liquidity Traps.” Review of Economic Dynamics 31 (January): 182– 99.
- Reifschneider, David L., and John C. Williams. 2000. “Three Lessons for Monetary Policy in a Low-Inflation Era.” Journal of Money, Credit and Banking 32, no. 4 (November): 936– 66.
- Svensson, Lars E. O. 1999. “Price Level Targeting vs. Inflation Targeting: A Free Lunch?” Journal of Money, Credit and Banking 31, no. 3 (August): 277– 95.
- ________ . 2019. “Monetary Policy Strategies for the Federal Reserve.” Mimeo, Stockholm School of Economics
- Taylor, John B. 1985. “What Would Nominal GDP Targeting Do to the Business Cycle?” In Carnegie-Rochester Conference Series on Public Policy 22: 61– 84.
- ________ . 1993. “Discretion versus Policy Rules in Practice.” Carnegie-Rochester Conference Series on Public Policy 39 (December): 195– 214
- Vestin, David. 2006. “Price-Level versus Inflation Targeting.” Journal of Monetary Economics 53, no. 7 (October): 1361– 76.
- Woodford, Michael. 2003. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton. NJ: Princeton University Press.
APPENDIX A: UPPER BOUND
The various conditions determine whether a constraint never binds, ; occasionally binds, ; or always binds,
- Takatoshi Ito, Andrew K. Rose, Takatoshi Ito, Andrew K. Rose(Authors)
- 2007(Publication Date)
- University of Chicago Press(Publisher)
There are two broad sets of lessons worth highlighting from this sum-mary. The first concerns the appropriate level of the steady-state neutral nominal interest rate—the sum of the economy’s neutral real interest rate and policymakers’ choice of target inflation rate. From table 2.1 we see that, even for a very low neutral nominal interest rate of i ∗ 3 percent, in most scenarios the ZLB has relatively little e ff ect on the thinking of an ac-tivist policymaker until the bubble has become quite large. 25 Moreover, as figures 2.3, 2.6, and 2.8 confirm, even those “ZLB e ff ects” in table 2.1 that Monetary Policy, Asset-price Bubbles, and the Zero Lower Bound 71 Table 2.1 Impact of the ZLB on an activist’s recommendations Scenario Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Policy can’t affect bubble p t = 0.2, baseline model = = = – – – p t = 0.4, baseline model = = = = = – p t = 0.4, β = 0.5 = = – – – – p t = 0.4, λ = 0.6 = = = = = = p t = 0.4, λ = 1.0 = = = = – – Policy affects bubble growth = = = = – – Policy affects probability of bursting p * = 0.4, δ = 0.2 = = + + – – Note: Tighter (+), looser (–), or little different (=) than otherwise, i * = 3.0. 25. The two exceptions are: when the bubble’s probability of bursting may be influenced by policy; and when the bubble is exogenous but the economy is relatively unresponsive to poli-cymakers’ actions. In these two cases the “ZLB e ff ect” exceeds 25 basis points when the bubble is still only of a moderate size. are not negligible dissipate rapidly as the neutral nominal interest rate is raised above 3 percent. These observations suggest that fears of encountering the ZLB should not be overstated, unless the neutral nominal interest rate in the economy is very low. They thus have an obvious implication for policymakers anx-ious not to have to worry about factoring the ZLB into their thinking when trying to cope with an asset-price bubble.
eBook - PDFMonetary Policy in the Context of Financial Crisis
New Challenges and Lessons
- Fredj Jawadi, William A. Barnett(Authors)
- 2015(Publication Date)
- Emerald Group Publishing Limited(Publisher)
This will be neutral with respect to inflation if the equilibrium short-term real interest rate is 2%. 1 If inflation falls to say 0% and is expected from the time series evidence to stay there, the benchmark rule calls for an i * of 1%, or 3% below its normal level of 4%. This implies a real rate of 1%, which is less than its assumed equilibrium level of 2%, and hence would put upward pressure on inflation, driving it back toward the Fed’s announced target of + 2%. But if inflation falls to say − 2% (i.e., 2% de flation) and is expected to stay there, the benchmark rule calls for an impossibly negative i * of − 2%. Because of the Zero Lower Bound (ZLB) on nominal interest rates, the lowest i * can ordinarily go is 0%. This would imply a real rate of + 2%, which would not be stimulative at all, and so would permit inflation to drift even lower. With any deeper expected deflation, the ZLB would actually lead to an even higher real rate and further downward pressure on inflation, 1 The equilibrium real interest rate is that determined in the absence of a monetary disequilibrium by the supply and demand for saving, as in the “Loanable Funds Model” of Irving Fisher (1930/1974) . This is equivalent to Knut Wicksell’s “Natural Rate of Interest,” as discussed by Friedman (1968) . 406 J. Huston McCulloch which has led many economists to fear the possibility of an unstoppable deflationary spiral. This supposed ZLB threat has been used as a rationale for deliberately targeting a positive inflation rate in order to give the Fed some additional space to reduce nominal rates before hitting the ZLB, in spite of the Fed’s legislative mandate to stabilize prices. In 2012, the Fed in fact announced its intention to target 2% inflation, in part for this very reason. We will see that this fear is unwarranted. But first, let us consider how the Taylor Rule may be expected to operate when the ZLB is not binding.
eBook - PDFZero Lower Bound and Monetary Policy in the Euro Area
Optimal Monetary Policy in a Low Inflation Environment
- Lars Protze(Author)
- 2008(Publication Date)
- Diplomica Verlag(Publisher)
83 The second approach was followed to describe European inflation dynamics to evaluate the risk to hit the bound. 6.4 Is the zero bound really zero? There are several factors working in either direction that shift the zero bound to a value that may be above or below zero. A factor that raises the bound is an anonymity service that only money provides. 84 This is important for criminal activities. If a large share of the economy consists of black market activities and illegal employment it is possible that the bound rises to a value above zero. Some estimations for the euro area suggest that a substantial share of the economy consists of such activities. 85 A factor that lowers the bound is a benefit that only interest bearing risk less bonds (or interest paying accounts) have. This is the case when storing money has costs at the margin so that households accept negative interest rates up to the costs of holding cash. However, these costs are lower in developed countries with paper currency. In countries with gold currency or some other hard to store money thes costs can not be disregarded. 86 The euro area is a well developed economy so that these factors seem to be negligible. These points suggest that the zero bound may deviate but not to strong so that the bound can be considered to be “really” zero. 83 Coenen, Günther and Volker Wieland 2000 page 10. 84 Yates, Tony 2002 page 13. 85 See for example Enste, Dominik H. and Friedrich Schneider 2003. 86 Yates, Tony 2002 page 12. 86 7. Conclusions Is it really a problem? The model employed in the first part of the thesis showed that there exists a possibility to reduce the losses induced by the zero bound significantly. However, the ECB does not follow such a price level target rule and even if the ECB does it is not clear if the public believes the commitment. So in the model the zero bound does not represent a big problem. In reality it does indeed as the case of Japan made clear in an impressive way.
eBook - PDFThe Reform of Macroeconomic Policy
From Stagflation to Low or Zero Inflation
- J. Perkins(Author)
- 2016(Publication Date)
- Palgrave Macmillan(Publisher)
The result was a failure to sell govern- ment bonds at such a low rate. This implies that, in practice, a mone- tary authority will not be wise to attempt to reduce nominal interest rates to very low levels. The constraint on its actions is therefore much tougher than the fact that nominal interest rates cannot be negative. In fact, even with a zero rate of inflation, presumably the (nominal) long-term rate would not normally be reducible much below about 3 per cent, and perhaps not even as low as that, without precipitating a sharp movement into cash and out of bonds. Monetary expansion would not necessarily be impaired in a country confronting a perfectly elastic liquidity schedule, if monetary policy is operating through the exchange rate. But if, because of a perfectly elastic liquidity schedule, the central bank is unable to reduce nominal interest rates further (relative to those in the rest of the world), there will not be the outward flow of capital which would in normal circum- stance lead to a weakening of the exchange rate. There will thus be no consequent stimulus to the level of domestic demand through depreci- ation. Exchange rate considerations do mean, on the other hand, that Low, Zero or Negative Inflation 187 the effect of fiscal policy will be enhanced by the existence of an infinitely elastic liquidity schedule. For the effect of a fiscal expansion, tending to increase interest rates, with a given setting of monetary policy, will not have their usual effect of raising interest rates if there is a perfectly elastic liquidity schedule. For in that case money will be released from speculative balances into transactions balances as the demand for money rises with the fiscal stimulus, without the need for any rise in interest rates (until, of course, the money released from the perfectly elastic part of the liquidity schedule has been exhausted).
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