willingness to undertake structural reforms. By contrast, sound fiscal positions mean less
need for fiscal adjustment and thus more room for reforms.
• The stronger the initial fiscal position, the greater the room is for fiscal policy to crowd in
resources in the wake of any structural reform that expands potential output but is not
necessarily accompanied by a corresponding expansion in aggregate demand. The case
for fiscal accommodation is most compelling for those reforms that change an economy’s
structural rate of employment, since such reforms would improve the cyclically-adjusted
budget balance corresponding to a given actual budget balance and employment rate.69
Put differently, not changing the actual budget balance post-reform and before
employment has had time to adjust would imply an effective tightening of fiscal policy.
This crowding-in argument needs to be qualified in a number of ways, however:
• Other mechanisms exist that allow the added supply capacity to be “crowded in”. In a
single country with an independent monetary policy, lower interest rates and exchange rate
depreciation could in principle boost demand and thereby allow the added supply capacity
to be “crowded in”. In a monetary union such as the euro area, the main - but slower -
mechanism for crowding in added supply is a lower real exchange rate brought about by a
period of slack and associated weak inflation. Given the nature of this latter mechanism,
the up-front costs of structural reform in a monetary union should be greater in large,
relative closed economies than in smaller, more open economies. This hints at possible
interactions between monetary policy autonomy and the fiscal position in facilitating or
hindering the reform process. In particular, the greater the ability of monetary policy to
crowd in resources in the wake of structural reforms, the smaller the need should be for
fiscal accommodation, and vice versa.
• The basic premise of the argument - that demand does not spontaneously expand in
response to added supply as a result of structural reform - is not straightforward. In
principle, rational and forward-looking households and firms should respond up-front to
the increase in, respectively, permanent income and output. The extent to which this
would happen in practice might depend on features of financial markets - in particular the
extent to which households enjoy wealth gains from higher share prices and firms are able
to secure financing on the basis of future production possibilities rather than pre-existing
collateral. In general, such spontaneous demand effects are likely to be weaker in
euro-area countries than in the United States, as also suggested by the experience of the
1990s.
• It is also the case that the balance between supply and demand effects of structural reform
is likely to depend on the nature of the structural reforms. Experience from many
countries suggests that structural reforms that remove restrictions in financial markets
may well stimulate demand more than supply in the short run. By contrast, it might be
thought that reforms in labour markets are susceptible to weaken demand in the short run
to the extent they may be associated with reduced public transfers and increased
69.Reforms differ in their impact on budgets. Reforms that boost productivity without raising equilibrium employment will have only limited
impacts on the cyclically-adjusted budget balance unless transfer recipients and public-sector employees do not share fully in the real income
gains created by higher productivity.
174