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Informality, Frictions and Monetary Policy

Author

Listed:
  • 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.

Suggested Citation

  • Nicoletta Batini & Paul Levine & Emanuela Lotti & Bo Yang, 2011. "Informality, Frictions and Monetary Policy," School of Economics Discussion Papers 0711, School of Economics, University of Surrey.
  • Handle: RePEc:sur:surrec:0711
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    File URL: https://repec.som.surrey.ac.uk/2011/DP07-11.pdf
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    References listed on IDEAS

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    Cited by:

    1. Adnan Haider & Musleh ud Din & Ejaz Ghani, 2012. "Monetary Policy, Informality and Business Cycle Fluctuations in a Developing Economy Vulnerable to External Shocks," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 51(4), pages 609-681.
    2. Ahmed, Shahzad & Ahmed, Waqas & Khan, Sajawal & Pasha, Farooq & Rehman, Muhammad, 2012. "Pakistan Economy DSGE Model with Informality," MPRA Paper 53135, University Library of Munich, Germany.
    3. Colombo, Emilio & Onnis, Luisanna & Tirelli, Patrizio, 2016. "Shadow economies at times of banking crises: Empirics and theory," Journal of Banking & Finance, Elsevier, vol. 62(C), pages 180-190.
    4. Lahcen, Mohammed Ait, 2014. "DSGE models for developing economies: an application to Morocco," MPRA Paper 63404, University Library of Munich, Germany.

    More about this item

    Keywords

    Informal economy; emerging economies; labour market; credit market; tax policy; interest rate rules;

    JEL classification:

    • J65 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment Insurance; Severance Pay; Plant Closings
    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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