The primary tool that central banks have to fight recessions is to cut interest rates so as to encourage enough borrowing and spending to return the economy to full employment. But as we experienced during the Great Recession, there is a natural limit to how low interest rates can go: It is known as the zero lower bound—or the effective lower bound. When the interest that banks pay on deposits reaches zero, lowering rates further means depositors earn a negative return—in other words, they must actually pay to deposit their money—making it more attractive to stuff cash in a mattress. At that point, monetary policymakers are left without their most tested method of stimulating demand.1

The Great Recession marked the first time in the postwar era that the zero lower bound became a relevant constraint for monetary policymaking worldwide.2 Unable to lower rates any further, the Federal Reserve and central banks in Europe and other developed countries struggled to deliver the additional monetary policy stimulus needed to counteract the deepest economic contraction since the 1930s, finally resorting, as I will discuss, to less proven, unconventional tools such as forward guidance and quantitative easing. Nine years on, economists are still debating the extent to which the lack of the primary monetary policy instrument contributed to the severity of the recession.

This article appeared in the First Quarter 2018 edition of Economic Insights. Download and read the full issue.

[1]Because there are costs to storing large amounts of cash, in practice central banks may be able to drive interest rates below zero. So, for all practical purposes, the effective lower bound occurs at whatever rate results in cash hoarding. Negative interest rates have been implemented in Europe and Japan to extend the scope of conventional monetary policy. See “Why Can’t Central Banks Simply Set Rates Below Zero?” on p.1 for details.

[2]The first country after the Great Depression to experience the zero lower bound was Japan, as I discuss later.