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Optimal monetary policy in developing countries: The role of informality

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  • Gomez Ospina, Monica A.

Abstract

In this paper, I analyze optimal monetary policy in developing countries whose labor markets are characterized by the presence of a large informal sector. I develop a closed economy model with nominal price and wage rigidities, search and matching frictions, and a dual labor market: a formal one characterized by matching frictions and nominal wage rigidities, and an informal one where wages are fully flexible. Under this framework, a trade-off between price and wage inflation emerges. I find that informality increases the response of price and wage inflation to aggregate productivity shocks. As a result, the presence of an informal sector increases the inefficient fluctuations of labor market variables, such as unemployment, labor market tightness, and formal hiring rate. I find that optimal policy with informality features significant deviations from price stability in response to aggregate productivity shocks.

Suggested Citation

  • Gomez Ospina, Monica A., 2023. "Optimal monetary policy in developing countries: The role of informality," Journal of Economic Dynamics and Control, Elsevier, vol. 155(C).
    • Handle: RePEc:eee:dyncon:v:155:y:2023:i:c:s0165188923001306
    DOI: 10.1016/j.jedc.2023.104724
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    More about this item

    Keywords

    Informality; Monetary policy; Nominal rigidities; Inflation targeting;
    All these keywords.

    JEL classification:

    • E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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