Interactions between Labor Market Reforms and Monetary Policy under Slowly Changing Habits

Abstract

Although central banks often advocate labor market reforms, the latter may lead to higher stabilization costs in the presence of habit persistence in consumption. This is more likely to occur when strong habit persistence is coupled with an inflation-averse central bank. The presence of habit formation is a non-negligible assumption: theoretically, it is now a well-established device used in New-Keynesian models in order to be data-consistent with the response of real spending to several shocks. Moreover, estimates of habit formation are, according to the literature, quite large. To capture the interactions between monetary policy and structural reforms, our model improves on the one presented in Aguiar and Ribeiro (2008) by including a job matching process that introduces additional labor market features through which a labor market reform can operate. Within this framework, we assess, across different policy rules, how labor market institutional changes impinge on the effectiveness of monetary policy. We have concluded that labor market reform reduces central banks' losses, as long as the degree of habit persistence is not too strong; however, alternative reform devices impinge differently on monetary policy effectiveness. Moreover, the inflation targeting rule accommodates positive permanent effects from the reform for a wider range of habit persistence. Even when habit persistence is high, reform may still reduce stabilization costs if the importance of both demand and technology shocks is low relative to cost-push ones.Monetary policy rules, Labor market reform, Labor market search and matching, New-Keynesian models