Inflation Dynamics in the Presence of Informal Labour Markets

28 Pages Posted: 24 Feb 2012

See all articles by Paul Castillo

Paul Castillo

affiliation not provided to SSRN

Carlos Montoro

Central Reserve Bank of Peru

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

Suggested Citation

Castillo, Paul and Montoro, Carlos, Inflation Dynamics in the Presence of Informal Labour Markets (February 1, 2012). BIS Working Paper No. 372, Available at SSRN: https://ssrn.com/abstract=2010494

Paul Castillo (Contact Author)

affiliation not provided to SSRN ( email )

Carlos Montoro

Central Reserve Bank of Peru ( email )

Jirón Miroquesada 441
Lima, Lima 1
Peru

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