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The global financial crisis and the sovereign debt crisis brought back to the policy debate the issue of the lower bound (LB) on interest rates and the policy options when this is a binding constraint. The paper looks at structural reforms as a way to provide economic stimulus for an economy at the lower bound. We focus in the euro area and carry out a comprehensive analysis within a multi-country structural model of the euro area within the world. Main results show structural reforms have positive short-run effects that reduce the size of a recession and in some cases can drive the euro area out of the LB. The labour reform accentuates deflation which implies that interest rates remain at the LB for the same number of periods, while the services reform pushes the euro area out of the LB if implemented in the largest part of the union. The latter result hinges on the assumption of a gradual implementation of reforms. Reforms have significantly different effects across different types of households and thus the share of these households is important in the transmission. Unilateral reforms in a large bloc have positive spillover effects within the euro area. Unilateral reforms in a small bloc are deflationary but the small size of the bloc leads to very limited impact of national developments on monetary policy.
5 Concluding remarks
This paper analyses the impact of implementing structural reforms when an economy that is in a deep recession that led interest rates to the lower bound. We focus on the euro area. While the long-run impact of an increase in competition in the labour and services markets is positive, the short term impact depends on a number of characteristics of an economy, including the response of monetary policy. We use a large scale fully structural model of the euro area because: (i) by being multi-sectoral it allows for investigating reforms in the services market and in the labour market; (ii) by being multi-country, in particular by formalizing the euro area as a two-bloc monetary union it allows us to analyse the issue of coordination and spillovers of reforms within the euro area; (iii) by including different types of agents it allows to explore the importance of having financially constrained agents for the reforms impact.
We find that structural reforms are short run positive impact, that the reforms have differentiated impact across different types of households, that unilateral reforms in a large bloc have positive spillover effects within the euro area, and that an increase in the share of constrained households reduces the short run macroeconomic benefits of reforms. A reform in the small bloc euro area bloc has very different results for inflation that in this case falls, as the large fall in nontradable inflation is not offset by changes in inflation of tradable goods. However given the very small size its impact on euro area monetary policy is negligible, thus enacting the reforms at the lower bound is no longer relevant.