Why Do Central Banks Push for Structural Reforms? The Case of a Reform in the Labor Market

In spite of being mainly concerned with stabilization policies, central banks in many developed countries often advocate the necessity of structural reforms. In turn, demand-side policies - such as monetary policy - can often help improving the political support of reforms (two-handed-approach). By arguing that labor market reforms influence the effectiveness of monetary policy, we assess if central banks have incentives to help promoting such reforms. In order to identify the channels through which the effects of the reform impinge on the effectiveness of monetary policy, we add stylized features of the labor market to a standard New Keynesian model for monetary policy analysis. In this framework, a labor market reform is modeled as a structural change inducing a permanent shift in the flexible prices unemployment and output levels. The reform-induced adjustments, under different sources of macroeconomic and reform implementation inertias, are then compared across different monetary policy rules. We find that, in general, labor market reform increases the effectiveness of monetary policy as a demand-management instrument. However, conditional to the presence of different inertias, the reform process can bring about transition stabilization costs, depending on the monetary policy rule. Choosing a particular monetary policy rule, as well as the business cycle timing of the reform, are means to reduce such costs.