Does informality facilitate inflation stability?

Summary

Focus

The paper assesses how informality affects inflation dynamics and monetary policy. Informality is captured by a dual labour market where the share of informal workers is driven by market demand and adjusts quickly. Only formal sector firms have access to financing, which is necessary for their production process. These elements are embedded in a standard general equilibrium framework with a Taylor rule for monetary policy. We explore the impact of different shocks on the dynamics of inflation and how the transmission channel of monetary policy is affected by informality.

Contribution

Informality is still an entrenched structural trait in emerging market economies. Informality determines the behaviour of labour markets, financial access and the productivity of the overall economy. Therefore, it influences the transmission of shocks and also of monetary policy. However, there is hardly research analysing the link between informality and monetary policy.

Findings

Informality provides higher flexibility to the labour market and buffers the impact of shocks on wages. Informality also operates through the credit cost channel: as the informal sector is excluded from credit markets, the sensitivity of unit costs to changes in interest rates is reduced. The paper has two main results: 1) the informal sector mitigates inflationary pressures arising from demand and financial shocks (but not of technology shocks); 2) the informal sector dampens the transmission channel of monetary policy: policy interventions are less effective in stabilising inflation and the sacrifice ratio is higher. Less effectiveness implies that monetary policy must react more strongly to deviations from inflation, but deviations would be smaller under most of the shocks. So, does informality facilitates inflation stability, making the job of monetary policy easier? At the light of our results, the answer is inconclusive.

Abstract

Informality is an entrenched structural trait in emerging market economies, despite of the progress achieved in macroeconomic management. Informality determines the behavior of labour markets, financial access and the productivity of the overall economy. Therefore it influences the transmission of shocks and also of monetary policy. This paper develops a simple general equilibrium closed economy model with nominal rigidities, labor and financial frictions. Informality is captured by a dual labour market where the share of informal workers is endogenous. Only formal sector firms have access to financing, which is instrumental in their production process. Informality has a buffering effect on the propagation of demand and supply shocks to prices; the financial feature of the model exacerbates the impact of financial shocks in the formal sector while the informal sector is in principle unaffected. As a result informality dampens the impact of demand and financial shocks on wages and inflation but heighten the impact of technology shocks. Informality also increases the sacrifice ratio of monetary policy actions. From a Central Bank perspective, the results imply that the presence of an informal sector mitigates inflation volatility for some type of shocks but makes monetary policy less effective.

JEL classification: E26, E31, E52

Keywords: informality, inflation, monetary policy