Introduction to monetary policy and bank regulation

The problem of the zero percent interest rate lower bound

Most economists believe that monetary policy (the manipulation of interest rates and credit conditions by a nation’s central bank) has a powerful influence on a nation’s economy. Monetary policy works when the central bank reduces interest rates and makes credit more available. As a result, business investment and other types of spending increase, causing GDP and employment to grow.

But what if the interest rates banks pay are close to zero already? They cannot be made negative, can they? That would mean that lenders pay borrowers for the privilege of taking their money. Yet, this was the situation the U.S. Federal Reserve found itself in at the end of the 2008–2009 recession. The federal funds rate, which is the interest rate for banks that the Federal Reserve targets with its monetary policy, was slightly above 5% in 2007. By 2009, it had fallen to 0.16%.

The Federal Reserve’s situation was further complicated because fiscal policy, the other major tool for managing the economy, was constrained by fears that the federal budget deficit and the public debt were already too high. What were the Federal Reserve’s options? How could monetary policy be used to stimulate the economy? The answer, as we will see in this chapter, was to change the rules of the game.