Nova workboard

a blog from young economists at Nova SBE

How the Zero Lower Bound affected Quantitative Easing

In the past years, a lot has change when we talk about monetary policy. After the financial crisis, European countries face unconventional instruments used by European Central Bank (ECB) in order to conduct the monetary policy of the European System and with the goal of stabilize the economies. And then, when the interest rates start to get negative values, the ECB have seen these policies become unpopular.

One of that instruments after crisis was the well-known Quantitative Easing. This instrument consists in purchases of government securities or other securities from the market by the ECB. This purchase will lead to decreases in the interest rates and increases in the money supply to encourage economic growth.

At this time, Economists believed that the interest rate cannot go below 0. So, when the actions of Central Bank lead to interest rate near zero, it will not go lower. But a question is generated: can quantitative easing still have effects at the Zero Lower Bound?

When we have the interest rate at the level of zero lower bound, the economy is in a liquidity trap, this means that any inflation or deflation are built based of expectations. To understand the role of expectations it is important that we review the concept of “Taylor rule”.

According to Taylor, the short-term interest rate is function of the interest rate that the CB wants to define (r), inflation (  and expectations about the level of inflation and the level of employment/output (Q). The capacity of CB to set the interest rate will increase if the agents believe in the CB intentions, i.e., the parameter  will match  and  will match  and the interest rate will be totally determined by inflation and real interest rate (chosen by CB).

When the Central Bank increases the money supply (Quantitative Easing), it is important that this action affects the future money supply because this is the variable that provide real effects. This permanent increase in money supply will lead to increase in prices and wages in the same proportion. So, if quantitative easing is expected to be reserved, it may have no effects on prices and then no effects on output as well.

So, if Quantitative Easing is credible over time, it will have real effects in the short-run even at the zero lower bound. This will be reflected in higher inflation expectations and lower interest rates, so in order to achieve effects with Quantitative Easing at the zero lower bound it is important to monitoring the developments in inflation expectations and policy-makers must find alternatives to keep the long-term inflation expectations credible.

However, this position was defended before some countries face a negative interest rate. All the arguments above were made assuming that the interest rate will not fall below 0, because facing negative interest rates people will prefer to hold money than buy bonds. The lower bound for interest rates is not zero anymore however economists like Tony Yates, Professor in University of Birmingham, are saying that the “zero lower bound” components are still there, just modified slightly by the costs of storing cash.

The purchases of sovereign debt have led to a decrease in the returns of bonds. This bond had become less attractive to investors and they move into riskier investments. Because the demand for bonds, when the interest rates were close to zero, was higher than the equilibrium, the interest achieved a negative value.

In the last year one problem has raised: how will the Central Bank react to the negative interest rates? Is this the end of the ECB dominance?

The first bank in the world to pass to the customers negative interest rates was Alternative Bank Schweiz (ABS) and other banks around the world, like Swiss National Bank (SNB) follow this behavior. This seems to be the latest weapon of central banks, in an attempt to support economic growth and inflation.

This happened because the Central Banks have run out of room to cut interest rates above zero and their quantitative easing schemes have become unpopular, so they had to present solutions. This negative interest rates should, in theory, boost the economy because forcing people to pay for have their money in the bank will lead to increase investment or consume.

However, negative rates are not achieving this boost in the economy, instead this interest rates are being seen as a sign that central banks have nothing left to solve the weak demand problem. In the last years, the fiscal policy has reduced its size and the monetary policy is the ultimate responsible to support economic demand.

Because buying sovereign debt is not working, one obvious place to go is buying corporate debt. However, if QE became unpopular, buying debt of largest companies will be even more so.

The goal of QE was to, with the increase in demand for government bonds, the interest rate will decrease and will be more attractive to investors and then inspire them to increase their demand for other investments which will boost the economy. But this effort to stimulate the economies faced a problem, the debt of the Eurozone is not consolidated and so ECB must buy bonds of the member states, in different quantities.

The Eurozone crisis of 2010-2011 brings the possibility of Eurozone break up and if this occurred it is better to own debt of a stable country like German than debt of a country like Portugal. Whatever the interest rate on Portugal bonds, the rate on German bonds is sure to be lower.

So, these negatives interest rates are a way to rescue these policies focused on interest rates. But there are limits on how far the negative rates can go. If it gets too steep, banks have an obvious alternative: get physical money and store it.

However, some solutions to make the negative interest rates more feasible start to appear. If the ECB or the Federal Reserve decides to raise its inflation targets, inflation-adjusted rates can go lower. However, the effectiveness of the current targeting regime wouldn’t be that high, and thus we’ll new to find a new framework to conduct the monetary policy.

The role of negative interest rates is very unknown because is a phenomenon too recent to check for effectiveness. We can affirm that this is the approach that the ECB is trying to explore and it have to overcome a few barriers in order to achieve the proposed results.

Ana Marques (3710)













[1] Evan F. Koening, Robert Leeson, George A. Kahn.The Taylor rule and the Transformation of Monetary Policy

[2] 2016, Peter Spence. How negative interest rates marked the end of central bank dominance. Available at

[3] 2015, Matthew Yglesias. Something economists thought was impossible is happening in Europe. Available at

[4] 2016, Gail D. Fosler, Josh Tom. Are Negative Interest Rates and Quantitative Easing Compatible? An Interview with Christian Noyer. Available at




Author: studentnovasbe

Master student in Nova Sbe

Comments are closed.