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Optimal monetary policy in a dual labor market: the role of informality

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  • Gomez, M.

Abstract

In this paper I analyze the optimal monetary policy in emerging countries whose labor markets are mainly characterized by the presence of a large informal sector. I develop a closed economy model with nominal price and wage rigidities, search and matchingfrictions 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 the labor market variables, such as unemployment, labor market tightness, and formal hiring rate. I derive the second-order approximation to the welfare of the representative agent, and then I characterize the optimal monetary policy for standard calibration of the model. I find that optimal policy with informality features significant deviations from price stability in response to aggregate productivity shocks.

Suggested Citation

  • Gomez, M., 2020. "Optimal monetary policy in a dual labor market: the role of informality," Documentos de trabajo - Alianza EFI 19124, Alianza EFI.
    • Handle: RePEc:col:000561:019124
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    More about this item

    Keywords

    Informality; Monetary policy; Nominal wage and price 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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