Structural reforms, animal spirits, and monetary policies

We use a New Keynesian behavioral macroeconomic model to analyze how structural reforms affect the economy. There are two types of structural reforms. The first one increases price flexibility; the second one increases competition in the labor market and raises potential output. We find that in a rigid economy business cycle movements are dominated by movements of animal spirits. Increasing price flexibility reduces the power of animal spirits and the boom bust nature of the business cycle. We study the trade-offs between output and inflation volatility faced by the central bank. We find that flexibility improves these trade-offs making it easier for the central bank to stabilize output and inflation.