The ma roe onomi e�e ts of stru tural reformsUsing DSGE models to assess the impa t of reforms on e onomi resilien eEkkehard Ernst1 Gang Gong2 Willi Semmler31E onomi s DepartmentOECDekkehard.ernst�oe d.org2Department of E onomi sTsinghua UniversityBejing, China3Department of E onomi sNew S hool for So ial Resear hNew York, USASeminar at the Underse retariat of Treasury, AnkaraO tober 26th, 2007E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 1 / 28

Outline1 Motivation and main message2 Resilien e and stru tural poli ies: A model-based frameworkSome qui k re�e tions on e onomi resilien eHow to assess y li al e�e ts of stru tural reforms ?Sti ky pri es and labour market fri tions: how the model works3 Estimating stru tural poli y indi atorsEstimation of stru tural parameters4 Poli y experiments: Consequen es for onsumption smoothingCalibrating poli y experimentsVolatility and onsumption smoothing5 Trading o� volatility against e� ien yMeasuring welfare ostsWelfare-maximising stru tural poli ies6 Con luding remarksE. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 2 / 28

Motivation and main messageMotivation◮ Stru tural reforms o upy a entral pla e in poli y debates to improvelong-term performan e.◮ However, little is known about their impa t on short-term, y li alphenomena (e.g. e onomi resilien e)◮ Moreover, measuring the stan e of stru tural poli ies and reforms remains a hallenge.◮ Two main approa hes to measure stru tural poli ies have been identi�ed:

◮ Analyti al ex-post indi ators (OECD, World Bank, EU Commission)◮ Indu tive ex-ante indi ators (model-based)Motivation of my talk

◮ Present an appli ation of the indu tive approa h toassess the short-term, y li al impa t of poli y reforms.◮ Dis uss bene�ts and (some) drawba ks of model-basedindi ators for stru tural reforms.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 3 / 28

Motivation and main messageMain message◮ The paper applies the indu tive approa h to an analysis of the impa t ofstru tural reforms.◮ Most analysis in this area has on entrated on the role of reforms inimproving employment and produ tivity.◮ Here, the role of labour and produ t market reforms in a�e tingma roe onomi adjustment to sho ks will be emphasised.

=⇒E onomi resilien e as a short-term lever for stru tural reforms.Main message of my talkStru tural reforms a�e t resilien e by enhan ing possibilitiesto onsumption smoothing over the business y le.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 4 / 28

Motivation and main messageOverview of the talk◮ Some qui k re�e tions on e onomi resilien e◮ How to assess y li al e�e ts of stru tural reforms ?◮ Sti ky pri es and labour market fri tions: how the model works◮ Estimating stru tural poli y indi ators◮ Poli y experiments: Consequen es for onsumption smoothing◮ Trading o� volatility against e� ien y◮ Con luding remarks

E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 5 / 28

Resilien e and stru tural poli ies: A model-based framework Some qui k re�e tions on e onomi resilien eWhat do we mean when we talk about resilien e?◮ Resilien e points to forms of e onomi dynami s that maximise welfare◮ Resilien e omes in several forms:Resilien e to (transitory) demand sho ksQui k nominal rea tion, weak or no rea tion ofquantities.Resilien e to (permanent) supply sho ksQui k quantity adjustment to the new steady state,qui k nominal rea tion to the new equilibrium ofrelative pri es.◮ Both forms of resilien e will have long-run e onomi onsequen es byredu ing the welfare osts of business y les and helping (risk-averse)households to smooth onsumption.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 6 / 28

Resilien e and stru tural poli ies: A model-based framework How to assess y li al e�e ts of stru tural reforms ?Model-based analysis of stru tural poli iesMethodologi al and poli y analysis advantagesMethodologi al advantages◮ Stru tural poli y indi ators an easily be interpreted be ause of lear mi rofoundations.◮ Several poli y dimensions an be overed that are orthogonalex ante.◮ In prin iple, time-varying stru tural poli y indi ators areavailable (but not presented here).Poli y analysis advantages◮ General equilibrium e�e ts of poli y hanges an be properlyassessed, no redu ed form model is ne essary.◮ Dynami e�e ts an be taken into a ount, whi h goes beyond omparative stati s.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 7 / 28

Resilien e and stru tural poli ies: A model-based framework Sti ky pri es and labour market fri tions: how the model worksWages and labour market fri tionsMain elements of the model: The labour marketWage dynami swt = ξ ·wt−1+(1− ξ )w∗t◮ Wages, therefore, do not adjust immediately to lear the labour market.◮ Similar to the spirit of mat hing models, transa tions are assumed to takepla e o� the optimal demand and supply s hedules:Employment transa tionsnt = ωndt +(1−ω)nst◮ A tual employment is expe ted to be loser to labour supply the stronger thebargaining position of insiders is.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 8 / 28

Resilien e and stru tural poli ies: A model-based framework Sti ky pri es and labour market fri tions: how the model worksSti ky pri es and the retail marginMain elements of the model: The produ t market◮ The model does not ontain any nominal variables, only relative pri es are onsidered.◮ Households buy the �nal good from the retail se tor either to onsume or toinvest.◮ The retail se tor is perfe tly ompetitive but buys its inputs frommonopolisti ally ompetitive intermediate goods produ ers.◮ This reates a mark-up in the intermediate goods se tor. Aggregateprodu tion is therefore smaller than with perfe t ompetition:Yt = (1− exp(λt)) ·Atkαt n1−αtE. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 9 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersEstimation methodology◮ The wage share α and the real wage rigidity ξ are dire tly taken from thedata.◮ The model's deep stru tural parameters are estimated in a �rst step based onthe ompetitive model (i.e. without produ t and labour market rigidities).

◮ This is done using an estimation strategy alled Generalised Methods ofMoments (GMM).◮ This method estimates dire tly the optimality onditions of the model.

◮ In a se ond step, labour and produ t market fri tions are introdu ed. Thestru tural poli y indi ators are then determined on the basis of:(ω ,λ ) = argmin∑t {nt − [

ωndt (Yt (λ ))+ (1−ω)nst ]}2◮ Drawba k of the method:

◮ Labour supply and labour demand are supposed to be independent, toguarantee su esfull identi� ation of the rigidity parameters.◮ This may not ne essarily be the ase in the data.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 10 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersEstimating preferen e and te hnology parametersCountry α β δ θ ξAustralia 0.58 0.999 0.024 3.18 0.99Austria 0.62 0.980 0.007 2.57 0.94Belgium 0.64 0.990 0.007 1.88 0.93Canada 0.61 0.969 0.021 1.76 0.99Denmark 0.60 0.985 0.015 2.57 0.93Finland 0.60 0.960 0.094 1.91 0.97Fran e 0.63 0.981 0.017 1.81 1.00Germany 0.61 0.985 0.017 1.80 1.01Ireland 0.59 0.980 0.015 1.79 0.99Italy 0.66 0.992 0.012 1.97 1.02Japan 0.68 0.999 0.008 2.20 0.97Korea (Rep.) 0.74 0.999 0.025 2.50 0.97Netherlands 0.62 0.983 0.022 1.87 0.98New Zealand 0.55 0.999 0.045 3.00 0.95Norway 0.54 0.999 0.052 2.93 0.98Portugal 0.64 0.975 0.032 1.93 0.97Spain 0.63 0.980 0.024 1.89 0.99Sweden 0.61 0.979 0.014 1.75 0.97Switzerland 0.60 0.988 0.014 2.58 0.98Turkey 0.64 0.983 0.022 1.97 0.84United Kingdom 0.65 0.978 0.011 1.80 0.97USA 0.64 0.960 0.053 1.78 0.98Note: The table reports the estimates of the stru tural parameters for the substitution elasti ity between apital and labour(α), the intertemporal time preferen e (β ), the depre iation rate of apital (δ ); the substitution elasti ity between labour onsumption and leisure (θ ) and the persisten e of real wages (ξ ).Sour e: Own al ulationsE. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 11 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersEstimating preferen e and te hnology parameters IIHow are parameters distributed in the ountry sample?A

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1.5 2 2.5 3 3.5Elasticity of substitution between consumption and leisureNote: The �gures present kernel density estimates of the ross- ountry distri-bution of estimated stru tural parameters (solid line) that are mat hed with anormal distribution (dashed line). Country positions are indi ated by droplines.

◮ Estimates for the deep stru tural parameters usually lie around standardvalues as found in the literature.◮ As the ountry sample is not random, the ross- ountry distribution ofestimated parameters does not ne essarily follow a normal distribution.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 12 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersEstimating produ t and labour market rigiditiesCountry ω λ EPL PMR GRR WBCAustralia 0.25 -7.21 1.10 1.26 0.27 3.3Austria 0.31 -6.01 2.39 1.81 0.26 4.3Belgium 0.00 -0.97 2.09 2.05 0.39 4.0Canada 0.18 -10.16 0.64 1.37 0.27 1.4Denmark 0.02 -1.02 1.49 1.46 0.41 3.8Finland 0.11 -1.06 2.09 2.07 0.44 4.8Fran e 0.01 -1.08 3.08 2.48 0.37 2.0Germany 0.12 -8.14 2.78 1.90 0.27 4.0Ireland 0.23 -8.74 1.01 1.47 0.26 3.1Italy 0.01 -1.03 3.28 2.78 0.05 2.9Japan 0.15 -8.52 2.65 1.86 0.10 4.0Korea (Rep.) 0.12 -3.64 2.00 2.47 N/A 1.0Netherlands 0.03 -1.13 2.36 1.79 0.46 4.1New Zealand 0.17 -7.17 1.03 1.43 0.27 2.8Norway 0.15 -11.34 2.89 1.83 0.39 4.3Portugal 0.37 -10.39 3.75 2.13 0.35 3.6Spain 0.00 -1.06 3.21 2.33 0.32 3.5Sweden 0.13 -10.75 2.43 1.80 0.29 3.3Switzerland 0.02 -0.98 1.27 2.24 0.30 4.0Turkey 0.51 -7.21 3.61 3.10 0.00 1.0United Kingdom 0.58 -9.15 0.51 1.15 0.18 1.6USA 0.47 -3.88 0.22 1.30 0.12 1.0Note: The table reports the estimates of the ω- and λ -parameters following the estimation pro edure des ribed in the text.In addition the table reports the OECD-indi ators for unemployment bene�ts gross repla ement rates ( olumn GRR), thelevel of wage bargaining oordination (WBC), the stri tness of employment prote tion legislation (EPL) and the tightnessof produ t market regulation (PMR).Sour e: Own al ulations, Conway et al. (2005), OECD (2004)E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 13 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersIdenti� ation of stru tural rigidites IThe ω -parameter, in parti ular, does not have a natural interpretation:◮ We have put forward four hypotheses, to assess whi h poli ies are identi�edby the ω -parameter:

◮ Higher repla ement rates → raise workers' bargaining power → lower �rms' apa ity to adjust employment a ording to their labour demand.◮ Higher level of bargaining oordination → in rease nominal wage sti kiness →hamper relative wage adjustments → lower the impa t of sho ks onemployment.◮ Stri ter employment prote tion → slows down labour adjustment → restri t�rms in their possibility to adjust employment to labour demand.◮ Stri ter produ t market regulation → slows down the speed of entry and exitsof �rms → aggregate employment will be a�e ted by labour hoarding andine� ient �rm restru turing.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 14 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersIdenti� ation of stru tural rigidites IIAUS

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◮ Labour market rigidities are identi�ed as related to the stri tness ofemployment prote tion legislation.◮ Some ountries seem to have a more �exible labour market than the legalprovisions would suggest (Portugal, Turkey).◮ The model-based indi ator hen e seems to re�e t also the appli ation of law.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 15 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersIdenti� ation of stru tural rigidites IIIAUS

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◮ Produ t market rigidities are similarly identi�ed and mat hed with availablepoli y indi ators from OECD sour es.◮ Generally, there is a positive relation between the λ -parameter and the OECDprodu t market regulation indi ator.◮ Identi� ation is, however, less lear than with the ω-parameter as otherfa tors not re�e ted in the PMR indi ator may hamper produ t market ompetition.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 16 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersExplanatory power of the stru tural poli y indi atorsLambda and Productivity growth (1995-2005)

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◮ Corresponding to earlier OECD work, the estimated poli y indi ators are wellrelated to long-term ma roe onomi performan e:◮ Higher produ t market ompetition (i.e. lower λ) raises produ tivity growth(left panel)◮ Lower employment adjustment osts (i.e. higher ω) redu es unemployment(right panel)E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 17 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersIndu tive poli y indi ators ILessons learned so far - AdvantagesAdvantages of indu tive poli y indi ators◮ Have very low data requirements :

◮ In the above model only national a ounts data are required;◮ Are stri tly model-based and have a lear e onomi meaning:

◮ Indu tive indi ators re�e t a tual market fri tions rather than legalpros riptions (e.g. Portugal, Turkey).◮ Intera tions between rigidities are taken into a ount.

◮ Are obtained via statisti al method ⇒ allow measuring their un ertainty.◮ Not exploited here, but in prin iple possible.

E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 18 / 28

Estimating stru tural poli y indi ators Estimation of stru tural parametersIndu tive poli y indi ators IILessons learned so far - Some drawba ksSome drawba ks◮ Depending on the model and the statisti al approa h, long time-series arerequired (no time variation of parameters);

◮ New te hniques allow for mu h shorter time-series (e.g. Bayesian estimations),but still need to over some 20 years.◮ The model imposes strong restri tions on the data that may not be veri�ed:

◮ Example: the above independen e between labour supply and demand urvesis not veri�ed in e� ien y wage models;◮ May la k poli y perspe tive (depends on the modelling approa h).

◮ Example: Measured nominal and real wage rigidites (su h as in Blan hard andGali, 2006) do not lead to immediate poli y pres riptions.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 19 / 28

Poli y experiments: Consequen es for onsumption smoothing Calibrating poli y experimentsPoli y simulations: Methodology◮ Stru tural reforms on labour markets an be identi�ed with hanges in ω :Less employment prote tion translates into higher values for ω .◮ Similarly, stru tural reforms on produ t markets an be identi�ed with hanges in λ : Less produ t market regulation translates into lower values for

λ .◮ Maximum and minimum values for the two parameters identify the possiblepoli y spa e: best-pra ti e OECD ountries have highest ω and lowest λ .◮ In order to assess the hanges in volatility and e onomi welfare, a poli y gridof 10×10 poli y ombinations has been set up and simulations for �vedi�erent ountries has been arried out.

E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 20 / 28

Poli y experiments: Consequen es for onsumption smoothing Volatility and onsumption smoothingChanges in volatility IStru tural reforms help to redu e onsumption volatility, but may in reaseindividual employment risks.Lowest ω ,highest λImprovementof ω

Improvementof λ

Simultaneousimprovementof ω and λConsumption 6.46 5.60 6.44 5.43Capital 6.74 6.05 6.75 6.03Employment 22.44 20.73 22.72 21.95Produ tion 36.96 27.92 37.21 27.90Austria Wages 94.54 94.53 94.61 94.57Consumption 3.55 3.48 3.51 3.28Capital 2.09 2.70 2.08 2.55Employment 3.20 9.30 3.25 11.78Produ tion 7.81 7.56 7.89 8.69Fran e Wages 92.59 92.59 92.59 92.58Consumption 3.87 3.47 3.84 3.34Capital 3.47 3.25 3.45 3.17Employment 7.95 8.47 8.03 10.94Produ tion 14.61 10.99 14.68 11.55Germany Wages 163.66 163.77 163.62 163.25Note: The table shows the volatility (varian e) of the main ma roe onomi aggregates resulting from5000 simulations when di�erent values for and are implemented. Four poli y situations have been sele ted:(i) ω and λ are set at their most restri tive estimated values; (ii) ω is improved to the least restri tiveestimate, λ is left un hanged, (iii) λ is improved to the least restri tive estimate, ω is left un hanged,and �nally (iv) both ω and λ are improved to their least restri tive estimated values.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 21 / 28

Poli y experiments: Consequen es for onsumption smoothing Volatility and onsumption smoothingChanges in volatility IIThe trade-o� between lower onsumption volatility and higher employmentvolatility is a general feature.Lowest ω ,highest λImprovementof ω

Improvementof λ

Simultaneousimprovementof ω and λConsumption 3.85 3.64 3.79 3.48Capital 2.42 2.39 2.40 2.37Employment 5.85 8.59 5.91 10.54Produ tion 11.96 9.93 12.00 10.58Italy Wages 364.27 454.23 364.46 357.75Consumption 4.96 4.72 4.89 4.55Capital 2.92 2.76 2.92 2.79Employment 10.26 12.39 10.32 14.19Produ tion 19.44 15.73 19.45 16.25Japan Wages 94.62 94.62 94.61 94.61Consumption 2.73 2.38 2.70 2.28Capital 2.64 2.33 2.63 2.30Employment 3.85 4.02 3.89 4.05Produ tion 7.69 4.02 7.71 5.76Turkey Wages 11.66 11.68 11.66 11.67Note: The table shows the volatility (varian e) of the main ma roe onomi aggregates resulting from5000 simulations when di�erent values for and are implemented. Four poli y situations have been sele ted:(i) ω and λ are set at their most restri tive estimated values; (ii) ω is improved to the least restri tiveestimate, λ is left un hanged, (iii) λ is improved to the least restri tive estimate, ω is left un hanged,and �nally (iv) both ω and λ are improved to their least restri tive estimated values.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 22 / 28

Poli y experiments: Consequen es for onsumption smoothing Volatility and onsumption smoothingCy li al e� ien y and onsumption smoothingStru tural reforms help onsumption volatility de line relative to employmentvolatility. The same does not unambiguously apply with respe t to produ tionvolatility.Relative onsumptionvolatility Lowest ω ,highest λImprovementof ω

Improvementof λ

Simultaneousimprovementof ω and λAustria 0.288 0.270 0.283 0.247Fran e 1.110 0.374 1.081 0.279Germany 0.488 0.409 0.479 0.305Italy 0.658 0.424 0.641 0.331Japan 0.484 0.381 0.474 0.321Turkey withrespe tto employment 0.707 0.592 0.694 0.563Austria 0.175 0.201 0.173 0.195Fran e 0.454 0.461 0.445 0.377Germany 0.265 0.316 0.262 0.289Italy 0.322 0.367 0.316 0.329Japan 0.255 0.300 0.251 0.280Turkey withrespe tto produ tion 0.354 0.407 0.350 0.396Note: The table presents the relative volatility of onsumption both with respe t to employment and wages as ameasure of intertemporal risk sharing when di�erent values for ω and λ are implemented. Four poli y situationshave been sele ted: (i) ω and λ are set at their most restri tive estimated values; (ii) ω is improved to the leastrestri tive estimate, λ is left un hanged, (iii)λ is improved to the least restri tive estimate, ω is left un hanged,and �nally (iv) both ω and λ are improved to their least restri tive estimated values.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 23 / 28

Trading o� volatility against e� ien y Measuring welfare ostsE onomi welfare e�e ts of stru tural reforms I◮ The in rease in employment volatility implies a risk to e onomi well-being,due to the risk averse nature of the household.◮ We estimate the welfare osts of onsumption and employment volatility onthe basis of:

Welfare Costs =12σ2 + θ

12σ2Nwith σ2 : onsumption varian e and σ2N : employment varian e, a�e ting theutility of households in our model.◮ The trade-o� between onsumption smoothing and employment volatilitydepends on:

◮ The initial regulatory position;◮ the relative weight of onsumption versus employment volatility in the welfarefun tion (i.e. θ );◮ the in rease of employment volatility relative to the hange in the varian e of onsumption.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 24 / 28

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Austria and BelgiumFull and en ompassing reforms arewelfare-maximisingE. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 25 / 28

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�Germany and ItalyFull liberalisation of produ t markets, butalready intermediate deregulation of labourmarkets are su� ient to maximise welfare.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 26 / 28

Trading o� volatility against e� ien y Welfare-maximising stru tural poli iesE onomi welfare e�e ts of stru tral reforms IV

TurkeyPoli y omplementarities arise. Only simultaneous andradi al reforms an allow to swit h from one equilibrium tothe other.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 27 / 28

Con luding remarksCon lusion and outlookWhat have we learned so far?◮ Improving the fun tioning of either the labour or the produ t market helps tolower onsumption volatility and to in rease onsumption smoothing.◮ This may ome at the ost of raising employment (and produ tion) volatility.◮ E onomi welfare is generally improved when stru tural reforms areimplemented (at least partially).Future resear h on reform indi ators◮ The model does not yet allow to a ount for �nan ial market rigidities, norfor nominal rigidities (arising from wage bargaining).◮ A further extension should also onsider more diverse sho ks (demand,money, labour supply).◮ The parameter spa e may be enri hed, time-varying parameters onsideredand on�den e intervals estimated around the poli y parameters.E. Ernst et al. (OECD) E�e ts of stru tural reforms Ankara, 2007 28 / 28