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Definition: Zero-Bound Interest Rate
Monetary policy involves adjusting the interest rate according to the situation in an economy. When there's growth incentive needed in the economy, Central Banks (such as the RBI, Federal Reserve) often adjut their interest rate by lowering it down - making credit available at a cheaper rate and thereby enabling liquidity into the economy. On the other hand, when inflation is high, interest rate is adjusted upwards so as to empower higher savings, lower liquidity in the economy and thereby curbing the inflation rates.
The lowest percentage that a central bank can set therefore, is 0%. This is in nominal interest rate measures which also implies that the central bank can not reduce the interest rates any further to encourage economic growth. The closer the interest rate approaches the zero bound (0%), the effectiveness of monetary policy reduces. The zero-bound interest rate implies a process where owing to gradual adjustments of the interest rate, it approaches zero.
A typical example used is that of Bank of Japan - the Central Bank of Japan hovering its interest rate around zero. This is done to encourage inflation - a lacking feature of the Japanese economy. Since banks normally increase interest rates to slow growth down, a zero-bound interest rate policy is often an outcome following a period of significant economic pullback or slowdown.
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