Inflation Dynamics in the Presence of Informal Labour Markets

This paper examines the adjustment of developing country labor markets to macroeconomic shocks. It models a two sector labor market: a formal salaried (tradable) sector that may or may not be affected by union or legislation induced wage rigidities, and an unregulated (nontradable) self-employment sector facing liquidity constraints to entry. This is embedded i n a standard small economy macro model that permits the derivation of patterns of comovement among relative salaried/self-employed incomes, salaried/self-employed sector sizes and the real exchange rate with respect to different types of shocks in contexts with and without wage rigidities. The paper then explores time series data from Argentina, Brazil, Colombia and Mexico to test for cointegrating relationships corresponding to the patterns predicted by theory. We identify two types of regime. The first corresponds to periods where demand shocks to the nontradable sector offer new opportunities to (informal) entrepreneurs, the informal sector expands "procyclically," and the exchange rate overshoots toward appreciation in the short run, or remains at its productivity determined levels. The second corresponds to periods of negative shocks to the formal salaried sector in the presence of wage rigidities where the sector plays a more traditional "buffer" role during downturns.

Bulletin of Economic Research, 2015

In this paper we build an endogenous growth model in which the informal economy is subject to a cash-in-advance constraint along with physical capital accumulation and consumption. In this setting, we find that inflation generally adversely affects long-run growth. However; this effect strongly interacts with the size of the informal economy. Specifically, the negative effect becomes milder (and can even be positive) under the presence of a large informal economy. Moreover, using an annual crosscountry panel data set of 161 countries over the period 1950-2010 we also provide some empirical support for the mechanism of our theory.

2009

This paper reviews the literature on the informal economy, focusing first on empirical findings and then on existing approaches to modelling informality within both partial and general equilibrium environments. We concentrate on labour and credit markets, since these tend to be most affected by informality. The phenomenon is particularly important in emerging and other developing economies, given their high degrees of informal labour and financial services and the implications these have for the effectiveness of macroeconomic policy. We emphasize the need for dynamic general equilibrium (DGE) and ultimately dynamic stochastic general equilibrium (DSGE) models for a full understanding of the costs, benefits and policy implications of informality. The survey shows that the literature on informality is quite patchy, and that there are several unexplored areas left for research.

2017

This paper studies the optimal long-run rate of inflation in a two-sector model of the Lithuanian economy with informal production and price rigidity in the regular sector. The government issues no debt and is committed to follow a balanced budget rule. The informal sector is unregulated and untaxed and its existence limits the government’s ability to collect revenues through fiscal policy. Such environment provides therefore the basis for quantifying the possible existence of a public finance motive for inflation. The main results can be summarized as follows: First, there is a strong heterogeneity in the optimal inflation rate which depends on the tax rate that is endogenously adjusted to keep the budget balanced. Inflation can be as high as 6.77% when the capital tax rate is endogenous, but when labor income taxes are adjusted optimal policy calls for a rate of deflation such that the nominal interest rate hits the zero lower bound. Second, the optimal inflation rate is a non-dec...

IMF Working Papers, 2010

This paper reviews the literature on the informal economy, focusing first on empirical findings and then on existing approaches to modelling informality within both partial and general equilibrium environments. We concentrate on labour and credit markets, since these tend to be most affected by informality. The phenomenon is particularly important in emerging and other developing economies, given their high degrees of informal labour and financial services and the implications these have for the effectiveness of macroeconomic policy. We emphasize the need for dynamic general equilibrium (DGE) and ultimately dynamic stochastic general equilibrium (DSGE) models for a full understanding of the costs, benefits and policy implications of informality. The survey shows that the literature on informality is quite patchy, and that there are several unexplored areas left for research.

Journal of Economic Studies, 2015

Purpose The purpose of this paper is to study the implications of borrowing constraints characterizing the informal sector for macroeconomic volatility. Design/methodology/approach To this end, the author develops a simple dynamic stochastic general equilibrium model wherein registered activity not only is the basis to determine tax liabilities, but also serves as collateral for securing debts. Such a framework allows for computational experiments to analyze the effect of informality on aggregate fluctuations. Findings The experiments show that the credit-constrained informal sector does exert a significant influence on the cyclical volatility of consumption and investment. Originality/value There are not many studies addressing the implications of informal economic activities for macroeconomic fluctuations. This paper contributes to the literature by developing a theoretical model showing that credit constraints characterizing these activities might play a non-negligible role in explaining the cyclical volatility of some important aggregates.

CSAE working paper, University of Oxford

This paper analyses the factors that give rise to the existence of the informal economy and how it evolves over time. Using an occupational-choice model the paper shows that at early stages of development, informal and formal markets coexists, but in the long-run the size of the informal economy can decline depending on the initial distribution of wealth. The model shows that the higher the initial wealth inequality the larger the size of the informal economy and the higher the wealth inequality will be in the long run. The paper calibrates the model using numerical simulations.

Journal of Development Economics, 2012

This paper presents a search and matching model to account for the most salient facts of labor markets with informal jobs in developing countries. The data suggests that workers reallocate from formal jobs into informal jobs in recessions, as well as when policy makers intervene in the market. This reallocation is mainly driven by the large and procyclical swings of the job …nding rate in the formal sector relative to the stability of the job …nding rate in the informal sector. The model captures this fact by assuming that …rms operate the intra-…rm margin of formality, choosing to legalize only those matches that are good enough to compensate the costs of formality. In this framework, recessions or stricter regulations in the labor market trigger two e¤ects. As expected, they lower the incentives to post vacancies (meeting e¤ ect), but also a¤ect the …rms'hiring standards, favoring informal contracts (o¤ er e¤ ect). This new channel sheds light on how the actions of policy makers alter the outcomes in an economy with informal jobs. For instance, attempts to protect employment by increasing …ring costs will reallocate workers to the "unprotected" informal sector, where job destruction is high. They are also likely to increase unemployment.

Iza Discussion Papers, 2006

* We thank Mauricio Santamaría for stimulating conversations that inspired our interest in this topic. We also thank Bob Hussey and Fabien Postel-Vinay for their helpful comments. 1 According to Maloney (2004), the informal sector includes 30 to 70 percent of urban workers in Latin American countries. 2 Schneider and Enste (2000) give estimates for a wide range of countries. They calculate that the informal sector accounts for 10 to 20 percent of GDP in most OECD countries, 20 to 30 percent in Southern European OECD countries and in Central European transition economies. They calculate that the informal sector accounts for 20 to 40 percent for the former Soviet Union countries and as much as 70 percent for some developing countries in Africa and Asia.

Journal of Development Economics, 2010

a b s t r a c t JEL classification: F41 J21 J24 J31 017

Review of Economic Dynamics, 2015

This paper documents how informal employment in Mexico is countercyclical, lags the cycle and is negatively correlated to formal employment. This contributes to explaining why total employment in Mexico displays low cyclicality and variability over the business cycle when compared to Canada, a developed economy with a much smaller share of informal employment. To account for these empirical findings, a business cycle model is built of a small, open economy that incorporates formal and informal labor markets, and the model is calibrated to Mexico. The model performs well in terms of matching conditional and unconditional moments in the data. It also sheds light on the channels through which informal economic activity may affect business cycles. Introducing informal employment into a standard model amplifies the effects of productivity shocks. This is linked to productivity shocks being imperfectly propagated from the formal to the informal sector. It also shows how imperfect measurement of informal economic activity in national accounts can translate into stronger variability in aggregate economic activity.

Economic Insights - Trends and Challenges, 2023

This paper presents a theoretical model that draws from the neoclassical school of thought to examine the impact of a dominant informal sector on monetary policy transmission in developing economies. The model accounts for the interactions between the formal and informal sectors and explores the channels through which monetary policy affects the economy. The findings reveal that a significant informal sector can weaken the effectiveness of monetary policy transmission, as informal sector participants may not respond to policy changes in the same way as formal sector participants. Additionally, the informal sector may use alternative channels for financing and transactions, bypassing the formal banking system and limiting the transmission of monetary policy.

The Economic Journal, 2009

* We thank Mauricio Santamaría for stimulating conversations that inspired our interest in this topic. We also thank Bob Hussey and Fabien Postel-Vinay for their helpful comments. 1 According to Maloney (2004), the informal sector includes 30 to 70 percent of urban workers in Latin American countries. 2 Schneider and Enste (2000) give estimates for a wide range of countries. They calculate that the informal sector accounts for 10 to 20 percent of GDP in most OECD countries, 20 to 30 percent in Southern European OECD countries and in Central European transition economies. They calculate that the informal sector accounts for 20 to 40 percent for the former Soviet Union countries and as much as 70 percent for some developing countries in Africa and Asia.

IDS Bulletin, 2008

2013

We analyze, in this paper, the optimality of pro-cyclical monetary policy in the presence of informal sector. Our findings suggest that monetary tightening only in case of severe shock with high leverage ratio and that conventional monetary policy favors both the formal and informal sectors irrespective of the severity of the shocks and hence the whole economy if the size of informal sector is significantly large. Furthermore, fixing exchange rate is better policy option if objective is to defend the employment or domestic consumption from falling when negative shock hits the economy. We can not found any disproportionate impact of policies on informal sector. This may be due to static nature of the model and it might be possible that dynamics of responses of the two sectors to shocks differ significantly.