Question

What is the problem of the zero lower bound? O A The central bank cannot reduce the money supply below zero. O B The fiscal authority cannot reduce taxes below zero. O C The central bank cannot reduce the interest rate below zero. O D The fiscal authority cannot reduce debt below zero.

Answer 1

The correct answer to the above question is,

Problem of zero lower bound means the central bank cannot reduce the interest below zero (Option C)

Zero lower bound is related to the easing monetary policy by the central banks. Normally during the time of recession and slow growth central banks use monetary policy as a tool to improve liquidity in the system and lower borrowing cost. Lower rate of interest would promote higher borrowing for capital expenditure thus providing growth momentum to economy.

However the central banks cannot reduce the interest to below zero as at this level the monetary policy would not give any result. The reason being the when central banks issues paper currency guaranteed by governments, which gives a zero nominal interest rate banks would simply hold cash and not prefer to lend it to public as they do not have any incentive in lending to the people. This situation is also described as liquidity trap,