The Relevance of Decreasing Returns and Trend Inflation for Reforms at the Zero Lower Bound

Should an economy implement reforms during a deep crisis? A vast body of literature has evolved around this question. Early studies, based on standard New Keynesian models, suggested that reforms can be harmful when an economy is constrained by the zero lower bound. More recent research uses complex models to show which model assumptions influence this conclusion. In contrast, we take a simple model and show that two seemingly trivial assumptions significantly affect the result: the returns to labor in the production function and the presence of trend inflation. While trend inflation alone dampens the negative effect of the reforms, decreasing returns to labor can entirely reverse their short-run impact.