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Optimal Monetary Policy in the Presence of an Informal Sector and Firm-Level Credit Constraints

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  • Ahmed, Waqas
  • Khan, Sajawal
  • Rehman, Muhammad

Abstract

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.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 53169.

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Date of creation: 2013
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Handle: RePEc:pra:mprapa:53169

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Keywords: Informal Sector; Credit Constraints; Exchange Rate; Monetary Policy;

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  1. Choudhary, M. Ali & Hanif, M. Nadim & Khan, Sajawal & Rehman, Muhammad, 2010. "Procyclical Monetary Policy and Governance," MPRA Paper 27022, University Library of Munich, Germany.
  2. Lawrence J. Christiano & Christopher Gust & Jorge Roldos, 2002. "Monetary Policy in a Financial Crisis," NBER Working Papers 9005, National Bureau of Economic Research, Inc.
  3. Devereux, Michael B & Poon, Doris, 2004. "A Simple Model of Optimal Monetary Policy with Financial Constraints," CEPR Discussion Papers 4370, C.E.P.R. Discussion Papers.
  4. Sebastian Edwards, 2001. "Exchange Rate Regimes, Capital Flows and Crisis Prevention," NBER Working Papers 8529, National Bureau of Economic Research, Inc.
  5. Merola, Rossana, 2010. "Optimal monetary policy in a small open economy with financial frictions," Discussion Paper Series 1: Economic Studies 2010,01, Deutsche Bundesbank, Research Centre.
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