Are Supply-side Reforms Contractionary at the Zero Lower Bound?*

What is it about?

It has been argued that supply-side reforms, if implemented when the nominal interest rate is at the zero lower bound (ZLB), can have a contractionary effect on the economy. This is because, with lower expected inflation due to reforms, real interest rates rise, leading to a decline in aggregate demand. European structural reforms, in particular, may impede economic recovery if their negative effects are not offset by long-term efficiency gains, as some reforms may be short-lived due to political considerations. However, a new Keynesian model with sticky prices and wages offers a different perspective on the potential impact of supply-side reforms at the ZLB. When reforms reduce price markups, two opposing forces come into play: one deflationary and one inflationary. On the one hand, the deflationary force arises from the decline in expected inflation, which leads to an increase in the real interest rate and a decrease in aggregate demand. On the other hand, the inflationary force arises from the increase in real wages, which leads to an increase in inflation expectations and a decrease in the real interest rate. If wages are stickier than prices and reforms are expected to be shorter-lived than the ZLB, the inflationary force is likely to dominate, making the reforms expansionary. This suggests that even temporary European reforms can stimulate the economy, contrary to what some previous studies have found. In addition, permanent supply-side reforms can also be effective at the ZLB, depending on how people expect the central bank to act in the future. If people expect the central bank to reduce nominal interest rates away from the ZLB, output will increase in the future, creating a wealth effect. If this gain is not negated by monetary policy, the reforms can be expansionary. Previous studies have not taken this into account. In conclusion, the impact of supply-side reforms at the ZLB depends on the relative stickiness of wages and prices, as well as the expected duration of the reforms compared to the ZLB. Under certain conditions, these reforms can be expansionary, even at the ZLB. It is important to consider these specific economic conditions when evaluating the potential impact of supply-side reforms.

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Photo by Zwaddi on Unsplash

Photo by Zwaddi on Unsplash