Escaping Expectations-Driven Liquidity Traps: Experimental Evidence

We explore the ability of monetary policy and central bank communication to stabilize expectations and alleviate the duration and severity of liquidity traps in learning-to-forecast macroeconomic laboratory experiments. Economic crises are generated by exogenous aggregate demand shocks that gradually dissipate over time. Monetary policy is set via a Taylor rule that either targets inflation around a constant or state-dependent inflation target. Expectations signifi-cantly over-react to the shock leading many economies to experience inescapable deflationary traps. State-dependent inflation targets, expressed either quanti-tatively or qualitatively, do not reduce the duration or severity of economic crises, and in many cases worsen the crisis. Past realized inflation and output are consistently used across all treatments in forming forecasts. Expectations are significantly more correlated with aggregate shocks when fundamentals im-prove faster following the crisis, suggesting an important role for fiscal policy to create demand and reverse adaptive deflationary traps. Combining a constant inflation target monetary policy with anticipated expansionary fiscal policy is highly e↵ective at stabilizing economic activity and increasing the speed of recovery