Zero interest rate policy
Encyclopedia
The zero interest rate policy (ZIRP) is a macroeconomic concept describing conditions with a very low interest rate
, such as contemporary Japan
and, since December 16, 2008, the United States
. It can be associated with slow economic growth.
Under ZIRP, the central bank
maintains a 0% nominal interest rate
. The ZIRP is an important milestone in monetary policy
because the central bank is no longer able to reduce nominal interest rates. Monetary policy is at its maximum potential to drive growth under ZIRP, because the central bank has no more tools left to stimulate borrowing. ZIRP is very closely related to the problem of a liquidity trap
, where nominal interest rates cannot adjust downward at a time when the loanable funds
market has not cleared.
When monetary policy is already used to maximum effect, to create further jobs governments must use fiscal policy
. The fiscal multiplier of government spending is expected to be larger when nominal interest rates are zero than they would be when nominal interest rates are above zero. Keynesian economics
hold that the multiplier is above one, meaning government spending effectively boosts output. In his paper on this topic, Michael Woodford
finds that, in a ZIRP situation, the optimal policy for government is to spend enough in stimulus to cover the entire output gap
.
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
, such as contemporary Japan
Japan
Japan is an island nation in East Asia. Located in the Pacific Ocean, it lies to the east of the Sea of Japan, China, North Korea, South Korea and Russia, stretching from the Sea of Okhotsk in the north to the East China Sea and Taiwan in the south...
and, since December 16, 2008, the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
. It can be associated with slow economic growth.
Under ZIRP, the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
maintains a 0% nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
. The ZIRP is an important milestone in monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
because the central bank is no longer able to reduce nominal interest rates. Monetary policy is at its maximum potential to drive growth under ZIRP, because the central bank has no more tools left to stimulate borrowing. ZIRP is very closely related to the problem of a liquidity trap
Liquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...
, where nominal interest rates cannot adjust downward at a time when the loanable funds
Loanable funds
In economics, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption...
market has not cleared.
When monetary policy is already used to maximum effect, to create further jobs governments must use fiscal policy
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....
. The fiscal multiplier of government spending is expected to be larger when nominal interest rates are zero than they would be when nominal interest rates are above zero. Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
hold that the multiplier is above one, meaning government spending effectively boosts output. In his paper on this topic, Michael Woodford
Michael Woodford (economist)
Michael Dean Woodford is an American macroeconomist and monetary theorist who currently teaches at Columbia University.-Academic career:...
finds that, in a ZIRP situation, the optimal policy for government is to spend enough in stimulus to cover the entire output gap
Output gap
The GDP gap or the output gap is the difference between potential GDP and actual GDP or actual output. The calculation for the output gap is Y*–Y where Y* is actual output and Y is potential output...
.
See also
- History of Federal Open Market Committee actionsHistory of Federal Open Market Committee actionsThis is a list of historical rate actions by the United States Federal Open Market Committee . The FOMC controls the supply of credit to banks and the sale of treasury securities. At scheduled meetings, the FOMC meets and makes any changes it sees as necessary, notably to the federal funds rate...
- Excess reservesExcess reservesIn banking, excess reserves are bank reserves in excess of the reserve requirement set by a central bank. They are reserves of cash more than the required amounts. Holding excess reserves is generally considered costly and uneconomical as no interest is earned on the excess amount...
- Federal funds rateFederal funds rateIn the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
- Keynesian endpointKeynesian endpointKeynesian endpoint is a phrase coined by PIMCO's Anthony Crescenzi in an email note to clients in June 2010 to describe the point where governments can no longer stimulate and rescue their economies through increased government spending due to endemic levels of pre-existing government debt."Time,...
- Liquidity trapLiquidity trapA liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...
- Negative interest rate
- Quantitative easingQuantitative easingQuantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...
- Real interest rateReal interest rateThe "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
- StagflationStagflationIn economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...
External links
- A Rate of Zero Percent From the Fed? Some Analysts Say It Could Be Coming
- Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment
- Fed Funds Rate: Turning Japanese, I Really Think So
- Nominal Interest Rates: Less Than Zero?
- Bank-of-Japan gives away money interest-free
- Rising Islamic bankers face surprise challenge from Fed
- Hopes for the Future of Islamic Finance