The zero lower bound (ZLB) occurs when the short-term nominal interest rate is at or close to zero, leading to a liquidity trap and restricting the central bank's ability to promote economic growth. Essentially, it signifies a point where interest rates cannot decrease any further below 0%.

The primary instrument of traditional monetary policy is interest rates, which are determined by a country's central bank (CB). When inflation is low and economic growth is negative, the central bank typically lowers interest rates to boost demand, hoping this will lead to increased economic growth.

However, if the central bank continues to reduce interest rates, there eventually comes a moment when rates reach zero and cannot be lowered any further. This situation is referred to as the zero lower bound (ZLB). At this stage, interest rates have hit their lowest point.

While it is technically feasible to set interest rates below zero, in practice, no one is likely to lend money at a negative interest rate, as individuals would prefer to hold cash instead. Consequently, the central bank loses the ability to utilize interest rates as a means to stimulate the economy.

This scenario is termed a liquidity trap. In a liquidity trap, increasing the money supply is often ineffective in spurring economic activity. Typically, a rise in the money supply results in lower interest rates, which encourages more spending. However, in a liquidity trap, people tend to be indifferent to an increase in the money supply, often because commercial banks are not lending to them, leaving them without access to this additional money.

As a result, interest rates do not decrease, and the surplus money is more likely to be saved rather than spent. In summary, while a reduction in interest rates usually promotes spending, in a liquidity trap, changes in the money supply do not alter spending behaviors. Therefore, conventional monetary policy becomes ineffective.

Examples of ZLB

In December 2008, the Federal Reserve (Fed) lowered interest rates to a range between 0% and 0.25%. The U.S. remained at the ZLB until 2013.

In March 2009, the Bank of England (BoE) reduced interest rates to 0.5%, maintaining that level until 2013.

In April 2020, the Fed, European Central Bank (ECB), and BoE all cut interest rates to zero in response to the COVID-19 pandemic.