The Liquidity Trap and the Zero Lower Bound
When the policy rate reaches its zero lower bound, conventional rate cuts lose their force. At a near-zero rate, money and short-term bonds become near-perfect substitutes, so injecting more reserves no longer pushes rates down. This liquidity trap is what motivates quantitative easing and forward guidance, which act on long rates and expectations instead of the short rate.
Why it matters
People hold cash for the convenience of liquidity and hold bonds for the interest. When the interest on offer is near zero, there is little reason to prefer a bond over cash, so extra money just gets held rather than spent or lent. The usual lever, making money cheaper, has nothing left to push on.
Worked examples
A central bank has cut its policy rate to zero, yet the economy is still weak and inflation is below target. Why might further injections of reserves do little, and what can it do instead?
At a zero short rate money and bills are near-perfect substitutes, so swapping one for the other barely moves spending. The bank turns to unconventional tools, buying long-term assets through quantitative easing to lower long rates and using forward guidance to lower expected future short rates.
Common mistakes
- ✗A central bank can always cut its way out of a downturn. Once the short rate hits zero, conventional cuts stop working and policy must turn to unconventional tools.
- ✗In a liquidity trap the central bank is completely powerless. It can still act on long rates and expectations through quantitative easing and forward guidance.
- ✗The zero lower bound is a hard physical floor at exactly zero. Some central banks pushed policy rates slightly negative, but the same near-substitute problem still blunts conventional policy near zero.
Revision bullets
- •At the zero lower bound conventional rate cuts lose traction
- •Money and bonds become near-perfect substitutes near a zero rate
- •Motivates quantitative easing and forward guidance
Quick check
In a liquidity trap, additional reserves do little to lower interest rates because
Connected topics
Sources
- Mishkin (2018), Ch. 16Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The zero-lower-bound problem and the case for nonconventional policy tools such as quantitative easing and forward guidance.