Question

"The ZLB on nominal interest rates can make it impossible for the Federal Reserve to prevent the economy from overheating".Is this statement correct? Explain your answer.

Answer 1

It is true that zero lower bound on nominal interest rate make it impossible for the Federal reserve to prevent the economy from overheating. The reason is that overheating is a feature of boom. It is a situation when there is rapid increase in demand and supply cannot be attained according to Demand and leads toward the inflation. In order to stop inflation there is need to decrease the demand by provoking people to do saving in banks. But it is not possible due to the ZLB on nominal interest rate. ZLB leads the interest rate near to zero. Due to less interest people prefer to consume the money rather to save and deposit in bank leads to increase in demand and inflation. Therefore, The ZLB on nominal interest rates can make it impossible for the Federal Reserve to prevent the economy from overheating".