DEFINITION: The phrase “zero bound,” or “zero lower bound,” refers to a monetary policy in which a central bank decreases short-term interest rates to zero.
The purpose of a zero-bound monetary strategy is to stimulate the economy by encouraging borrowing, spending, and investing.
The advisability of a zero bound policy is highly disputed. Even if it can be justified by its stimulative effect, a central bank must nevertheless exercise caution in implementing this approach, by, among other things, employing other measures to stimulate or revive the economy, as well, even if they are unconventional or controversial.
Thus, zero bound should only be considered in connection with relatively dire economic stagnation, when all other, more-conventional stimulative measures have failed.
ETYMOLOGY: The phrase “zero bound” probably goes back to the 1930s, when it was discussed as a theoretical possibility by Depression Era–policymakers. It was first implemented as actual policy by the US Federal Reserve in March of 2020.
The English word “zero” is attested from the early seventeenth century. It derives from either Middle French zéro or Italian zero, which both derive from Medieval Latin zephirum, which itself derives from Arabic ṣifr, all meaning “zero.”
The word zephirum, the Medieval Latin version of the Arabic ṣifr, was coined by the Italian mathematician Fibonacci (Leonardo of Pisa) in his Liber abaci [Book of Calculation] in 1202.
The English noun “bound,” in the mathematical sense derived from the closely related noun “boundary,” is attested from the thirteenth century. It derives, via Middle English, from Old French bodne, which, in turn, derives from Medieval Latin bodina.
USAGE: The phrase “zero bound” means the lower bound that interest rates may fall to, given that, while negative rates (meaning the owner pays the bank to hold his money for him) are theoretically possible, they are not usually practicable, at least in the context of a national government’s monetary policy.
Central banks manipulate interest rates in two main ways: either by reducing the prime rate (which is used as a benchmark by all other banks) to stimulate a stagnating economy or else by raising the prime rate to cool off an overheating economy.
Logically, there is no upper limit to how high the central bank can raise interest rates. However, there is a lower bound and that is obviously zero (once again, ignoring negative rates).
Assuming that interest rates ought not to be allowed to fall into negative territory, it may be presumed that once interest rates reach the zero bound, or approach very near to it (as with 0.1 percent rates, for example), then monetary-policy adjustments elsewhere in the system will be required to sustain or economic stability.
Perhaps the best-known substitute for further interest-rate cuts within a government’s monetary-policy toolkit is what is known as “quantitative easing” (QE). Quantitative easing is thus an adjunct to a zero-bound policy.
Quantitative easing involves the implementation by a central bank of an extensive program of the repeated purchase of assets, usually including Treasury bills and government bonds.
The goal of QE is not only to keep short-term interest rates (those of financial instruments with terms of one year or less) low, but also to reduce longer-term rates.
If successful, the combined policies of zero bound and quantitative easing may succeed in stimulating the economy by putting in place the requisite incentives to motivate increased borrowing.
The long-term sustainability of these novel and drastic policies, however, remains highly contentious.