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Monetary and Fiscal Policy in the Presence of Informal Labour Markets

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  • Batini, Nicoletta

    (IMF and University of Surrey)

  • Levine, Paul

    (University of Surrey)

  • Lotti, Emanuela

    (University of Surrey)

  • Yang, Bo

    (University of Surrey)

Abstract

How does informality in emerging economies affect the conduct of monetary and fiscal policy? To answer this question we construct a two-sector, formal-informal new Keynesian closed-economy. The informal sector is more labour intensive, is untaxed, has a classical labour market, faces high credit constraints in financing investment and is less visible in terms of observed output. We compare outcomes under welfare- optimal monetary policy, discretion and welfare-optimized interest-rate Taylor rules alongside a balanced-budget fiscal regime. We compare the model, first with no frictions in these two markets, then with frictions in only the formal labour market and finally with frictions on both credit markets and the formal labour market. Our main conclusions are first, labour and financial market frictions, the latter assumed to be stronger in the informal sector, cause the time-inconsistency problem to worsen. The importance of commitment therefore increases in economies characterized by a large informal sector with the features we have highlighted. Simple implementable optimized rules that respond only to observed aggregate inflation and formal-sector output can be significantly worse in welfare terms than their optimal counterpart, but are still far better than discretion. Simple rules that respond, if possible, to the risk premium in the formal sector result in a significant welfare improvement.

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Bibliographic Info

Paper provided by National Institute of Public Finance and Policy in its series Working Papers with number 11/97.

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Length: 42
Date of creation: Nov 2011
Date of revision:
Handle: RePEc:npf:wpaper:11/97

Note: Working Paper 97, 2011
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Web page: http://www.nipfp.org.in

Related research

Keywords: Informal economy ; Emerging economies ; Labour market ; Credit market ; Tax policy ; Interest rate rules;

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References

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Cited by:
  1. Adnan Haider & Musleh ud Din & Ejaz Ghani, 2012. "Monetary Policy, Informality and Business Cycle Fluctuations in a Developing Economy Vulnerable to External Shocks," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 51(4), pages 609-682.

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