Arifovic & Petersen: Escaping Expectations-Driven Liquidity Traps – Experimental Evidence

ABSTRACT:

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. The central bank sets nominal interest rates according to a Taylor rule that either targets inflation around a constant or state-dependent inflation target. Economic crises are generated by exogenous aggregate demand shocks that gradually dissipate over time. Expectations significantly over-react to the shock and, in many cases, the economies experience inescapable deflationary spirals. State-dependent inflation targets, expressed either quantitatively or qualitatively, do not reduce the duration or severity of economic crises, and in many cases worsen the crisis. Median expectations are significantly better anchored under a constant inflation target than a state-dependent target. In terms of heuristics used to form inflation forecasts, we observe considerable heterogeneity in participants usage of the aggregate shock or the inflation target, however past realized inflation is consistently used across all treatments. Expectations are significantly more correlated with aggregate shocks when the exogenous shocks trend faster back to the steady state, suggesting an important role for fiscal policy to create demand and reverse adaptive deflationary spirals.

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