Informal employment and business cycles in emerging market economies

We investigate how informal employment (hi) is relevant for shaping the aggregate dynamics in EMEs. Empirical evidence suggests that it is (i) countercyclical in Mexico, Colombia, and Turkey and (ii) negatively related to formal employment (hf) in Mexico and positively in Colombia and Turkey. To rigorously examine this empirical evidence, we build a small open economy model with both formal and informal labour markets, incorporating stationarity and trend shocks to TFP. As a novel contribution, we also allow for labour adjustment costs in the model to account for employment protection laws which differ across these economies. We then examine (i) the effect of changes in the degree of employment protection on hi and business cycles in EMEs and (ii) the extent to which hi acts as a buffer to the labour market in the face of adverse shocks. We find that this model can capture key stylized facts of the labour markets in these economies. Our model suggests that hi acts as a buffer and propagates positivity during adverse shocks given its countercyclicality while hf is pro-cyclical, findings supported by the documented empirical evidence. Regarding volatilities, hi does not act as a buffer since hf is more volatile than hi in the model which contrasts with the evidence in the data for these economies except Colombia.