"In a recent paper (Fernández-Villaverde et al 2010), we argue that supply-side policies can also play a role in fighting the perils of the zero lower bound. The argument is straightforward – any supply-side policy that raises future output (for instance, by improving productivity or by reducing markups) generates a wealth effect that increases the desire to consume today and decreases the excessive desire to save. Thus, supply-side measures address the core of the problem of the zero lower bound – the weakness of current aggregate demand. Supply-side policies are helpful precisely because there is a shortfall in aggregate demand.
We illustrate this mechanism with a simple two-period New Keynesian model. Prices are fixed in the first period but can be changed, at a cost, in the second period. This nominal rigidity makes output partially demand-determined. The representative household consumes, supplies labour, holds money, and saves. When the nominal interest rate is above zero, the household holds money to diminish transaction costs and saves in nominal bonds. When the nominal interest rate is zero (the nominal rate of return of money net of the marginal reduction of transaction costs), the household is indifferent between holding money or bonds. Because of price rigidity, prices cannot adjust as fast as they should and the real interest rate is not low enough to induce a sufficient level of consumption in the first period.
But if we suddenly increase productivity in the second period (or, alternatively, we lower the market power of firms), future output and consumption will rise. Because of the Euler equation of consumption, higher future consumption is followed by either higher interest rates and/or higher consumption today. This wealth effect of higher future output is translated into higher consumption, hours worked, and output today."
pay line :
"would the wealth effect be important enough? Unfortunately, we do not have a firm answer to this question simply because we have not been in this situation in recent decades"
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