policymakers demonstrate

440 Charles Brendon and Giancarlo Corsetti
remain high at t + 1 – that is, the economic state remains ‘bad’ – π t+1 is likely
to be lower for any given level of Y t+1 . Intuitively, an increase in productive
potential reduces inflation pressure. But once more, lower expected inflation
implies a higher real interest rate when the nominal rate is constrained at zero,
and this serves to reduce aggregate demand.
Eggertsson et al. (2014) calibrate their model to match salient features of
the Eurozone economy, and find that the second of these effects dominates
when the zero bound is binding. The long-run implications of structural reforms
remain positive: output in reforming countries increases by as much as 5 per
cent as a consequence, with positive spillovers additionally felt by the wider
region. The short-run consequence, however, is a worsening of the recession.
Fernández-Villaverde et al. (2014) place a slightly different emphasis on a
similar result. They show that supply-side reforms can help the economy to
emerge from a zero-bound trap, provided these reforms are only implemented
after the zero bound has ceased to bind. This overcomes the negative pricing
effect, so that current demand is affected only by an income effect. Here too,
the lesson for policy design is that crucial attention must be given to pricing
dynamics. There are beneficial effects to be had from structural reforms, just as
there may be from lower labour income taxes, but these can easily be dominated
if an effort is not made to offset deflationary consequences.
10.4.7 Empirical Evidence on the ‘Expectations Channel’
Coming in to the crises, very few economies had recent experience of the policy
trade-offs implied at the zero bound, of the sort that could be brought to
bear on the choice among alternative instruments. It is for this reason that
much of the debate has centred around theoretical exercises. Wieland (2014)
provides one of the few empirical attempts to understand whether the policy
models – particularly the New Keynesian framework – make the right predictions.
He studies the observed dynamics of output and inflation at the zero
bound, based on a combination of post-2008 data from the US, Eurozone, UK,
Canada and Sweden, and post-1995 data from Japan. His motivation is to investigate
whether ‘negative supply shocks’ – that is, unanticipated reductions in
economies’ productive potential – are expansionary at the zero lower bound.
This is one of the counterintuitive predictions that emerges in the New Keynesian
framework, and it operates for very similar reasons to those that mean
structural reforms can be contractionary. A negative shock to an economy’s
productive capacity, such as an earthquake or an oil price shock, will tend to
reduce long-run income, and this ought to have a negative impact on aggregate
demand. But at the same time there will be a positive effect on expected future
inflation so long as the zero bound binds: for any given level of actual output,
Y t+1 , a lower level of productive capacity will mitigate disinflationary pressure.
Wieland (2014) shows that this pricing effect can dominate dynamics at the