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Inflation Dynamics in the Presence of Informal Labour Markets

  • Paul Castillo
  • Carlos Montoro

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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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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  1. Christopher A. Pissarides, 2000. "Equilibrium Unemployment Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262161877, June.
  2. 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.
  3. Pierpaolo Benigno & Michael Woodford, 2005. "Inflation Stabilization And Welfare: The Case Of A Distorted Steady State," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1185-1236, December.
  4. Mark Gertler & Antonella Trigari, 2006. "Unemployment Fluctuations with Staggered Nash Wage Bargaining," Computing in Economics and Finance 2006 525, Society for Computational Economics.
  5. 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.
  6. Kolm, Ann-Sofie & Larsen, Birthe, 2006. "Does Tax Evasion Affect Unemployment and Educational Choice?," Working Papers 12-2003, Copenhagen Business School, Department of Economics.
  7. Olivier Blanchard & Jordi Galí, 2006. "Labor markets and monetary policy: A new-Keynesian model with unemployement," Economics Working Papers 1076, Department of Economics and Business, Universitat Pompeu Fabra, revised Mar 2008.
  8. Mariano Bosch, 2006. "Job Creation and Job Destruction in the Presence of Informal Labour Markets," CEP Discussion Papers dp0761, Centre for Economic Performance, LSE.
  9. Trigari, Antonella, 2004. "Equilibrium unemployment, job flows and inflation dynamics," Working Paper Series 0304, European Central Bank.
  10. Federico Ravenna & Carl E. Walsh, 2007. "Vacancies, Unemployment, and the Phillips Curve," Kiel Working Papers 1362, Kiel Institute for the World Economy.
  11. Carillo, Maria Rosaria & Pugno, Maurizio, 2004. "The underground economy and underdevelopment," Economic Systems, Elsevier, vol. 28(3), pages 257-279, September.
  12. Thomas, Carlos, 2008. "Search and matching frictions and optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 55(5), pages 936-956, July.
  13. Paul Levine & Emanuela Lotti & Nicoletta Batini & Young-Bae Kim, 2010. "Informal Labour and Credit Markets: A Survey," IMF Working Papers 10/42, International Monetary Fund.
  14. Krause, M.U. & Lubik, T.A., 2003. "The (Ir)relevance of Real Wage Rigidity in the New Keynesian Model with Search Frictions," Discussion Paper 2003-113, Tilburg University, Center for Economic Research.
  15. Maurizio Bovi, 2007. "Shadow Employment and Labor Productivity Dynamics," LABOUR, CEIS, vol. 21(4-5), pages 735-761, December.
  16. Chéron, A. & Langot, François, 1999. "The Phillips and Beveridge curves revisited," CEPREMAP Working Papers (Couverture Orange) 9905, CEPREMAP.
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