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Informality, Frictions and Monetary Policy

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Author Info

  • Nicoletta Batini

    (University of Surrey and IMF)

  • Paul Levine

    (University of Surrey)

  • Emanuela Lotti

    (University of Southampton and University of Surrey)

  • Bo Yang

    (University of Surrey)

Abstract

How does informality in emerging economies affect the conduct of monetary 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 building the model in stages; 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 in- creases 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 School of Economics, University of Surrey in its series School of Economics Discussion Papers with number 0711.

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Length: 43 pages
Date of creation: Jul 2011
Date of revision:
Handle: RePEc:sur:surrec:0711

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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. Emilio Colombo & Luisanna Onnis & Patrizio Tirelli, 2013. "Shadow economies at times of banking crises: empirics and theory," Working Papers 234, University of Milano-Bicocca, Department of Economics, revised Feb 2013.

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