Market Reforms at the Zero Lower Bound

IMF Working Papers, October 3, 2017

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This paper studies the impact of product and labor market reforms when the economy faces major slack and a binding constraint on monetary policy easing, such as the zero lower bound.
The authors build a two-country model with endogenous producer entry, labor market frictions, and nominal rigidities.
Core conclusion: while the effect of market reforms depends on the cyclical conditions under which they are implemented, the zero lower bound itself does not appear to matter. When carried out in a recession, the impact of reforms is typically stronger when the zero lower bound is binding.
Mechanism identified: reforms are inflationary in the structural model (or they have no noticeable deflationary effects), which alters the expected interaction between reforms and real marginal costs compared with reduced-form models that treat reforms as exogenous reductions in price and wage markups.

Framework: two-country general equilibrium model with
- endogenous producer entry,
- labor market frictions,
- nominal rigidities.
Comparative approach: analysis of reforms implemented under different cyclical conditions, including recessions with a binding zero lower bound on nominal interest rates.

The zero lower bound (ZLB) itself does not materially change the direction of reform effects; instead, cyclical conditions determine outcomes.
Reforms implemented in recessions typically have a stronger impact when the ZLB is binding.
Reforms are inflationary in the structural model, or have no noticeable deflationary effects.
There is no simple across-the-board relationship between market reforms and the behavior of real marginal costs, which contrasts with implications from reduced-form treatments that model reforms as exogenous reductions in price and wage markups.
This divergence significantly alters the consequences of the zero (or any effective) lower bound on policy rates.

Assessing the macroeconomic effects of product and labor market reforms requires structural analysis that allows for endogenous responses (entry, wages, prices) rather than relying on reduced-form markup reductions.
The inflationary tendency of reforms in the structural model suggests that the interaction with monetary policy constraints (like the ZLB) may amplify reform impacts during recessions.
Policymakers should consider cyclical conditions when sequencing or timing market reforms, as benefits may be magnified when monetary policy is constrained and the ZLB is binding.

Market Reforms at the Zero Lower Bound, WP/17/215, October 2017
- Market Reforms at the Zero Lower Bound, WP/17/215, October 2017 (Markdown version)
- Market Reforms at the Zero Lower Bound, WP/17/215, October 2017 (PDF)