Inflation Dynamics in the Presence of Informal Labour Markets
28 Pages Posted: 24 Feb 2012
Date Written: February 1, 2012
Abstract
In this paper 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. This finding 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, changes in interest rates are more effective in stimulating real output and there is less impact on inflation. Furthermore, the model produces cyclical flows from informal to formal employment, consistent with the data.
Keywords: Monetary Policy, New Keynesian Model, Informal Economy, Labour Market Frictions
JEL Classification: E32, E50, J64, O17
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