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Monetary and Fiscal Policy in the Presence of Informal Labour Markets

  • Batini, Nicoletta

    (IMF and University of Surrey)

  • Levine, Paul

    (University of Surrey)

  • Lotti, Emanuela

    (University of Surrey)

  • Yang, Bo

    (University of Surrey)

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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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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  1. Carlos Thomas, 2006. "Search and matching frictions and optimal monetary policy," LSE Research Online Documents on Economics 19782, London School of Economics and Political Science, LSE Library.
  2. Paul Levine & Joseph Pearlman & George Perendia & Bo Yang, 2010. "Endogenous Persistence in an Estimated DSGE Model under Imperfect Information," School of Economics Discussion Papers 0310, School of Economics, University of Surrey.
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  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. Mathan Satchi & Jonathan Temple, 2008. "Labour Markets and Productivity in Developing Countries," Studies in Economics 0805, School of Economics, University of Kent.
  16. Levine, Paul & McAdam, Peter & Pearlman, Joseph G., 2007. "Quantifying and sustaining welfare gains from monetary commitment," Working Paper Series 0709, European Central Bank.
  17. Paul Levine & Joseph Pearlman & Richard Pierse, 2006. "Linear-Quadratic Approximation, Efficiency and Target-Implementability," Computing in Economics and Finance 2006 441, Society for Computational Economics.
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