Escaping Expectations-Driven Liquidity Traps: Experimental Evidence

Abstract

Can monetary or fiscal policy stabilize expectations in a liquidity trap? We study expectation formation near the zero lower bound using a learning-to-forecast laboratory experiment. Monetary policy targets inflation around a constant or state-dependent target. Subjects’ expectations significantly over-react to stochastic aggregate demand shocks and historical information leading many economies to experience severe deflationary traps. Neither quantitative nor qualitative communication of inflation targets reduce the duration or severity of economic crises. A stronger initial recovery of fundamentals or supplementary anticipated fiscal stimulus stabilizes expectations and increases the speed of macroeconomic recovery.

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