Policy inertia, self-defeating expectations and structural reforms: can policy modeling cope?

Abstract

This paper tackles the relationship between structural reforms, policy inertia and agents’ expectations. By means of a stylized small-open economy encompassing barriers to entry in the non-tradable sector and political constraints’ associated with the risk of political instability in a context of heterogeneous agents (rentiers and non-rentiers), we show that alternative situations may materialize. One can have rational expectations equilibria where structural reforms are undertaken when expected (or not implemented when not expected), but also situations where agents’ expectations cannot be fulfilled. Thus, we maintain that economic models should take the possibility of self-defeating expectations into account for policymakers to exercise informed judgement, in particular about structural reforms. Some recent episodes in the euro area are discussed in the light of our model.