Monetary Policy and the Political Support for a Labor Market Reform

Lagged benefits relative to costs can politically block an efficiency-enhancing labor market reform, lending support to the two-handed approach. An accommodating monetary policy, conducted alongside the reform, could help bringing the positive effects of the reform to the fore. In order to identify the mechanisms through which monetary policy may affect the political sustainability of a reform, we add stylized features of the labor market to a standard New-Keynesian model for monetary policy analysis. A labor market reform is modeled as a structural change inducing a permanent shift in the flexible-price unemployment and output levels. In addition to the permanent gains, the impact of the timing and magnitude of the reform-induced adjustments on the welfare of workers - employed and unemployed - is crucial to the political feasibility of the reform. Since the adjustments depend, on one hand, on the macroeconomic structure and, on the other hand, can be influenced by monetary policy, we simulate various degrees of output persistence across different policy rules. We find that, if inertias are present, monetary policy, even when conducted by an independent central bank, affects the political support for the reform. In general, the more expansionary (or the less contractionary) the policy is, the faster is the recovery to the new steady-state equilibrium and, thus, the stronger is the political support.