Discussion Paper No. 1493 uses aggregate demand and supply analysis to investigate interactions between macroeconomic policy and structural maladjustment. Robert Gordon first uses a simple macroeconomic model to examine alternative policy responses to adverse supply shocks, and then addresses the applicability of the model by examining similarities between these shocks and the effects of structural maladjustments.

If structural reforms increase the flexibility of labour markets, they are likely to improve the short-run inflation-unemployment trade-off, providing an incentive for policy makers to expand aggregate demand. In turn, the promise by policy-makers to encourage a decline in unemployment in response to good news on inflation can be used to strike a political deal with interests opposed to structural reform. Expansionary monetary policy also provides relief on the fiscal front, directly, by bringing the actual deficit closer to the structural deficit, and indirectly, by encouraging structural reform, potentially reducing the structural deficit itself. The continued deceleration of inflation in the countries which dropped out of the ERM in 1992-3 provides empirical evidence that their natural unemployment rate has declined and that expansionary monetary policy has interacted beneficially with structural reform.

Macroeconomic Policy in the Presence of Structural Maladjustment
Robert J Gordon