Monetary and Fiscal Policy Design at the Zero Lower Bound: Evidence from the Lab

The global economic crisis of 2007-8 pushed many advanced economies into a liquidity trap, a macroeconomic scenario characterised by nominal rates at the zero lower bound (ZLB), low inflation and output below trend. We design an experiment to generate empirical evidence on the effectiveness of policies aimed at managing expectations against liquidity traps in a controlled laboratory environment where expectations are elicited directly from human subjects. Our results suggest that monetary policy alone is not sufficient to insulate the economy from the risk of falling into a liquidity trap, even if it preventively cuts the interest rate when inflation threatens to fall below a certain threshold. However, such policy augmented with a fiscal switching rule succeeds in avoiding and escaping liquidity trap episodes. We also measure larger-than-unity fiscal multipliers when monetary policy is constrained by the ZLB. Experimental results in different treatments are well explained by adaptive learning.

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