Short-Term Gain or Pain? A DSGE Model-Based Analysis of the Short-Term Effects of Structural Reforms in Labour and Product Markets

This paper explores the short-term effects of labour and product market reforms through a dynamic general equilibrium model that features endogenous producer entry, equilibrium unemployment and costly job creation and destruction. Unlike in existing work, the link between labour and product market dynamics and the policy factors driving it are modelled explicitly. The analysis yields three main findings. First, it takes time for reforms to pay off, typically at least a couple of years. This is partly because their benefits materialise through firm entry and increased hiring, both of which are gradual processes, while any reform-driven layoffs are immediate. Second, all reforms appear to stimulate GDP already in the short run, but some of them -- such as job protection reforms -- are found to increase unemployment temporarily. Implementing a broad package of labour and product market reforms enables governments to minimise or even alleviate such transitional costs. Third, reforms are not found to have noticeable deflationary effects, suggesting that the inability of monetary policy to deliver large interest rate cuts in their aftermath -- either because of the zero bound on policy rates or because the country belongs to a large monetary union -- may not be a relevant obstacle to reform implementation. Alternative simple monetary policy rules have little impact on the transitional costs from reforms.