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Inflation Dynamics in the Presence of Informal Labour Markets

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  • Paul Castillo
  • Carlos Montoro

Abstract

In this paper we analyse the effects of informal labour markets on the dynamics of inflation and on the transmission of aggregate demand and supply shocks. In doing so, we incorporate the informal sector in a modified New Keynesian model with labour market frictions as in the Diamond-Mortensen-Pissarides model. Our main results show that the informal economy generates a "buffer" effect that diminishes the pressure of demand shocks on inflation. This finding is consistent with the empirical literature on the effects of informal labour markets in business cycle fluctuations. This result implies that, in economies with large informal labour markets, changes in interest rates are more effective in stimulating real output and there is less impact on inflation. Furthermore, the model produces cyclical flows from informal to formal employment, consistent with the data.

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Bibliographic Info

Paper provided by Bank for International Settlements in its series BIS Working Papers with number 372.

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Length: 28 pages
Date of creation: Feb 2012
Date of revision:
Handle: RePEc:bis:biswps:372

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Keywords: Monetary Policy; New Keynesian Model; Informal Economy; Labour Market Frictions;

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References

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  1. Michael Woodford & Pierpaolo Benigno, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," 2004 Meeting Papers 481, Society for Economic Dynamics.
  2. Christopher A. Pissarides, 2000. "Equilibrium Unemployment Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262161877.
  3. Chéron, A. & Langot, François, 1999. "The Phillips and Beveridge curves revisited," CEPREMAP Working Papers (Couverture Orange) 9905, CEPREMAP.
  4. Boeri, Tito & Garibaldi, Pietro, 2006. "Shadow Sorting," CEPR Discussion Papers 5487, C.E.P.R. Discussion Papers.
    • Tito Boeri & Pietro Garibaldi, 2005. "Shadow Sorting," NBER Chapters, in: NBER International Seminar on Macroeconomics 2005, pages 125-163 National Bureau of Economic Research, Inc.
  5. Mariano Bosch, 2006. "Job Creation and Job Destruction in the Presence of Informal Labour Markets," CEP Discussion Papers dp0761, Centre for Economic Performance, LSE.
  6. Blanchard, Olivier J & Galí, Jordi, 2008. "Labour Markets and Monetary Policy: A New Keynesian Model with Unemployment," CEPR Discussion Papers 6765, C.E.P.R. Discussion Papers.
  7. Mark Gertler & Antonella Trigari, 2006. "Unemployment fluctuations with staggered Nash wage bargaining," Proceedings, Federal Reserve Bank of San Francisco.
  8. Carlos Thomas, 2006. "Search and Matching Frictions and Optimal Monetary Policy," CEP Discussion Papers dp0743, Centre for Economic Performance, LSE.
  9. Ravenna, Federico & Walsh, Carl E., 2008. "Vacancies, unemployment, and the Phillips curve," European Economic Review, Elsevier, vol. 52(8), pages 1494-1521, November.
  10. Maurizio Bovi, 2007. "Shadow Employment and Labor Productivity Dynamics," LABOUR, CEIS, vol. 21(4-5), pages 735-761, December.
  11. Krause, Michael U. & Lubik, Thomas A., 2007. "The (ir)relevance of real wage rigidity in the New Keynesian model with search frictions," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 706-727, April.
  12. Fugazza, Marco & Jacques, Jean-Francois, 2004. "Labor market institutions, taxation and the underground economy," Journal of Public Economics, Elsevier, vol. 88(1-2), pages 395-418, January.
  13. Antonella Trigari, 2004. "Equilibrium unemployment, job flows and inflation dynamics," Working Paper Series 304, European Central Bank.
  14. Nicoletta Batini & Young-Bae Kim & Paul Levine & Emanuela Lotti, 2009. "Informal Labour and Credit Markets: A Survey," School of Economics Discussion Papers 0609, School of Economics, University of Surrey.
  15. Carillo, Maria Rosaria & Pugno, Maurizio, 2004. "The underground economy and underdevelopment," Economic Systems, Elsevier, vol. 28(3), pages 257-279, September.
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Cited by:
  1. Senbeta, Sisay R., 2013. "Informality and Macroeconomic Fluctuations: A Small Open Economy New Keynesian DSGE Model with Dual Labour Markets," Working Papers 2013002, University of Antwerp, Faculty of Applied Economics.

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