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Inflation Dynamics in the Presence of Informal Labour Markets

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  • Paul Castillo B.
  • Carlos Montoro Ll.

Abstract

We analyze the effects of informal labor 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 labor 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. Finding that is consistent with the empirical literature on the effects of informal labor markets in business cycle fluctuations. This result implies that in economies with large informal labor markets the interest rate channel of monetary policy is relatively weaker. Furthermore, the model produces cyclical flows from informal to formal employment consistent with the data.

Suggested Citation

  • Paul Castillo B. & Carlos Montoro Ll., 2012. "Inflation Dynamics in the Presence of Informal Labour Markets," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 15(1), pages 4-31, April.
    • Handle: RePEc:chb:bcchec:v:15:y:2012:i:1:p:4-31
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    2. Owolabi, Adegboyega O. & Berdiev, Aziz N. & Saunoris, James W., 2022. "Is the shadow economy procyclical or countercyclical over the business cycle? International evidence," The Quarterly Review of Economics and Finance, Elsevier, vol. 84(C), pages 257-270.
    3. Bracha, Anat & Burke, Mary A., 2018. "Wage inflation and informal work," Economics Letters, Elsevier, vol. 171(C), pages 159-163.
    4. Yépez, Carlos A., 2019. "Informality and international business cycles," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 62(C), pages 252-263.
    5. repec:nbp:nbpbik:v:47:y:2016:i:6:p:395-434 is not listed on IDEAS
    6. 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.
    7. SENBETA, Sisay Regassa, 2013. "Informality and macroeconomic fluctuations: A small open economy New Keynesian DSGE model with dual labour markets," Working Papers 2013002, University of Antwerp, Faculty of Business and Economics.
    8. Jan Przystupa & Ewa Wróbel, 2016. "Modelling monetary transmission in less developed emerging markets: the case of Tunisia," Bank i Kredyt, Narodowy Bank Polski, vol. 47(5), pages 395-434.
    9. McKenzie, Rex A, 2015. "Monetary transmission in Africa: a review of official sources," Economics Discussion Papers 2015-7, School of Economics, Kingston University London.
    10. Central Reserve Bank of Peru, 2023. "eru: labour market, wages and monetary policy in the aftermath of Covid-19," BIS Papers chapters, in: Bank for International Settlements (ed.), Inflation and labour markets, volume 127, pages 221-236, Bank for International Settlements.
    11. Céspedes, Nikita, 2015. "Creación y Destrucción de Empleos e Informalidad," Working Papers 2015-009, Banco Central de Reserva del Perú.
    12. Peters Idowu & Yaaba N. Baba & Adetoba O. Olufunso & Tomologu-Okunomo E. Aduni & Tonuchi E. Joseph, 2020. "How Effective is Monetary Policy in the Presence of High Informality in Nigeria," Journal of Accounting, Business and Finance Research, Scientific Publishing Institute, vol. 10(2), pages 84-93.

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