Working Paper: CEPR ID: DP12336
Authors: Paul De Grauwe; Yuemei Ji
Abstract: We use a New Keynesian behavioral macroeconomic model to analyze how structural reforms affect the nature of the business cycle and the capacity of the central bank to stabilize output and inflation. We find that structural reforms that increase the flexibility of wages and prices can have profound effects on the dynamics of the business cycle. Our main finding here is that there is an optimal level of flexibility (produced by structural reforms). We also find that in a rigid economy the central bank in general faces a tradeoff between output and inflation volatility. This tradeoff disappears when the economy becomes sufficiently flexible. In that case the central bank’s efforts at stabilizing inflation and output are always welfare improving.
Keywords: behavioural macroeconomics; structural reforms
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| structural reforms that increase wage and price flexibility (E69) | dynamics of the business cycle (E32) |
| optimal level of flexibility produced by structural reforms (E69) | stabilization of output and inflation (E63) |
| in a rigid economy (P19) | tradeoff between output and inflation volatility (E31) |
| increased flexibility (D29) | dissipates tradeoff between output and inflation volatility (E31) |
| flexible economy (P19) | less volatility in the output gap and animal spirits (E32) |
| structural reforms that raise potential output (E69) | positive supply shocks (E65) |
| positive supply shocks (E65) | enhances economy's response to shocks (F41) |