Zero Lower Bound

Question 1

Zero Lower Bound (ZLB)

Answer 1

Central bank cuts interest rates →
• Hits 0% → can’t cut further (ZLB) →
• If rates go negative →
 • People hold cash to avoid losses
 • Commercial banks now pay the central bank to hold excess reserves.
• Central bank loses power to boost demand
• Real interest rate is what drives saving vs. spending choices so if Real i interest rate stays too high →
• Spending and investment stay low →
• Output gap stays negative →
• Economy stuck in a slump

Why offer negative rates?
→ To push people to spend or invest, not save
→ Used in Europe, Japan, Switzerland after crises

Problem:
→ Can’t go far below 0% — people withdraw and hold cash
→ ZLB limits traditional monetary policy

Question 2

How to Escape the Zero Lower Bound

Answer 2

1. Forward Guidance
   → Central bank promises low rates for longer
   → Shapes expectations → people spend/invest now
2. Quantitative Easing (QE)
   → Central bank buys bonds → adds money to the economy
   → Lowers long-term rates
   → Boosts lending, cheaper asset prices, e.g house spending
   → Weakens currency → more exports
   → Raises inflation expectations
3. Fiscal Policy
   → Government spends or cuts taxes
   → Direct boost to demand
   → Very effective at ZLB (monetary policy is weak)
4. Raise Inflation Target
   → Higher expected inflation
   → Lowers real interest rate even if nominal = 0%
   → More room to stimulate demand

Question 3

Four Lessons for Monetary Policy

Answer 3

Neutrality: Money sets inflation, not long‑run GDP → aim for price stability.
→ Football: overall fitness level decides the season; flashy tricks don’t fix stamina.
• Credibility: Trusted target moves expectations now → smaller output loss.
→ Football: teammates obey a captain they believe always keeps his word.
• Lags: Data‑to‑impact delays mean gradual, rule‑like moves beat big swings.
→ Football: a coach’s instructions take time to reach strikers—early, steady signals work best.
• Channels: Policy works via spending, FX, asset prices, bank credit—watch them all.
→ Football: goals come from many routes—crosses, through‑balls, set‑pieces, rebounds.

Mnemonic to lock it in:
F‑C‑T‑R → Fitness, Captain, Timing, Routes.

Question 4

Open‑Economy Trilemma — the Rule

Answer 4

A country can have only two of these three at once:
1. Fixed exchange rate (peg the currency)
2. Independent monetary policy (set your own interest rate)
3. Free capital flows (money moves in/out freely)

Why?
If capital is free to move and the exchange rate is fixed, investors chase the higher interest rate. To keep the peg, the home rate must match the foreign rate → no policy freedom. Try all three and either the peg breaks or you lose control of rates.

Question 5

Trilemma — Pick‑Two Combinations

Answer 5

1. Fixed exchange rate + Free capital flows
   • The country must shadow the foreign interest rate, giving up control of its own monetary policy.
   • Football image: You lock the scoreboard to match the other team’s score; now every time they attack, you must mirror their moves.

Fixed exchange rate + Independent monetary policy
• To keep different interest rates, the country must block or tax cross‑border money (capital controls).
• Football image: You insist on your own tactics while freezing the score, so you close the stadium gates—no new fans (money) in or out.

Independent monetary policy + Free capital flows
•	The exchange rate must be allowed to float up and down each day.
•	Football image: You open the gates and play your preferred style; the scoreboard is free to change with every goal.