Questions: Zero Lower Bound on Nominal Interest Rates

Question 1

The Taylor rule prescribes a nominal interest rate of −4% for a severely depressed economy. The central bank can only cut its policy rate to 0%. What is the direct consequence of this gap?

• A. The central bank can still achieve the prescribed rate by printing money directly
• B. Real interest rates remain too high to restore full employment through conventional policy
• C. Fiscal policy is automatically crowded out and becomes less effective
• D. Inflation expectations rise to close the gap, restoring the real rate to its target

Answer: (B)

When the ZLB binds, the central bank cannot deliver the negative nominal rate the Taylor rule prescribes. Real interest rates (nominal minus expected inflation) may therefore remain above their full-employment target, leaving borrowing and investment too expensive. Option C is precisely backwards: at the ZLB, fiscal policy is *more* effective because the central bank will not raise rates to offset stimulus (no crowding out). Option D is wishful thinking — in a depressed economy, inflation expectations typically fall, which *raises* real rates further.

Question 2

At the zero lower bound, what happens to the fiscal policy multiplier compared to normal times?

• A. It shrinks to zero because private spending substitutes one-for-one with government spending
• B. It is unchanged because monetary policy does not interact with fiscal policy
• C. It grows larger because the central bank will not raise rates in response to the stimulus
• D. It shrinks because the government must borrow, crowding out private investment

Answer: (C)

In normal times, fiscal expansion can trigger the central bank to raise rates preemptively, crowding out some private spending (partial offset). At the ZLB, the central bank *wants* more demand and has already cut rates as far as it can — it will not tighten in response to fiscal stimulus. This means government spending generates more additional output than it would in normal times: the ZLB paradoxically makes fiscal policy its most powerful instrument precisely when monetary policy is weakest.

Question 3

Once a central bank hits the zero lower bound, it has exhausted most its policy tools and can do hardly anything further to stimulate the economy.

• T. True
• F. False

Answer: False

The ZLB constrains *conventional* monetary policy — cutting the short-term policy rate. But central banks retain unconventional tools: quantitative easing (purchasing long-term assets to compress term premiums and yield spreads), forward guidance (credibly committing to keep rates low for an extended period to shape expectations), and in some cases negative interest rate policy on bank reserves. These tools operate through different transmission channels than the short-term rate. The ZLB marks the end of one toolkit, not all tools.

Question 4

At the ZLB, falling inflation expectations can cause real interest rates to rise even though the nominal rate remains fixed at zero.

• T. True
• F. False

Answer: True

This is one of the ZLB's most dangerous dynamics. The real interest rate equals the nominal rate minus expected inflation. If the nominal rate is stuck at zero and inflation expectations fall from, say, 2% to −1%, the real rate rises from −2% to +1% — tightening financial conditions without any central bank action. A contractionary spiral can result: weak demand lowers inflation expectations, raising real rates, which further weakens demand. This is the modern formalization of Keynes's liquidity trap, where conventional monetary easing becomes impossible precisely when it is most needed.

Question 5

Why does the existence of physical cash create a lower bound on nominal interest rates, and roughly where does that bound sit?

Model answer: Cash earns a nominal return of exactly zero. If a bank offered deposit rates significantly below zero, depositors could withdraw funds and hold physical currency instead, earning zero rather than a negative rate. This arbitrage puts a floor on how far rates can fall — approximately zero. In practice the floor is slightly below zero (some central banks have implemented small negative rates) because holding large quantities of physical cash is costly and inconvenient, but deep negative rates are not feasible without triggering mass cash hoarding.

The key insight is that cash is a zero-interest-bearing asset that anyone can hold. The ZLB is therefore not an institutional rule or policy choice — it is a consequence of this basic arbitrage. Central banks cannot mandate that people accept negative nominal returns on the safest possible asset. This contrasts with real interest rates, which have no such constraint and can be arbitrarily negative (as they have been in many economies with low nominal rates and positive inflation).