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Optimal Monetary Policy in the Presence of Sizable Informal Sector and Firm Level Credit Constraint


  • Waqas Ahmed

    (State Bank of Pakistan)

  • Sajawal Khan

    (State Bank of Pakistan)

  • Muhammad Rehman

    (State Bank of Pakistan)


We analyze optimality of pro-cyclical monetary policy in the presence of informal sector and firm level constraint. Our findings suggest that in case of export demand shock pro-cyclical monetary policy suits only when shock is severe and domestic firms have high leverage ratio. However, the conventional monetary policy helps cushioning the loss in output when the size of informal sector is significantly large. Furthermore, fixing exchange rate is better policy option if objective is to keep domestic employment or consumption from falling (when negative shock hits the economy). We cannot find any disproportionate impact of monetary policy 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.

Suggested Citation

  • Waqas Ahmed & Sajawal Khan & Muhammad Rehman, 2016. "Optimal Monetary Policy in the Presence of Sizable Informal Sector and Firm Level Credit Constraint," SBP Working Paper Series 72, State Bank of Pakistan, Research Department.
  • Handle: RePEc:sbp:wpaper:72

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    Cited by:

    1. Khurrum S. Mughal & Friedrich G. Schneider, 2020. "How Informal Sector Affects the Formal Economy in Pakistan? A Lesson for Developing Countries," South Asian Journal of Macroeconomics and Public Finance, , vol. 9(1), pages 7-21, June.
    2. Khurrum S. Mughal & Friedrich G. Schneider & Faheem Aslam & Alishba Tahir, 2021. "Money Multiplier Bias Due to Informal Sector: An Extension of the Existing Money Multiplier," South Asian Journal of Macroeconomics and Public Finance, , vol. 10(2), pages 139-157, December.

    More about this item


    Informal sector; credit constraint; exchange rate and monetary policy;
    All these keywords.

    JEL classification:

    • F0 - International Economics - - General
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements
    • O23 - Economic Development, Innovation, Technological Change, and Growth - - Development Planning and Policy - - - Fiscal and Monetary Policy in Development
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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