Firm Dynamics, Informality, and Monetary Policy

Yépez Carlos A. ()
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Yépez Carlos A.: Department of Economics, University of Manitoba, Rm. 644 Fletcher Argue Bldg., R3T 5V5, Winnipeg, MB, Canada

The B.E. Journal of Macroeconomics, 2025, vol. 25, issue 2, 951-978

Abstract: A prominent structural feature of many developing countries is the presence of a large shadow or informal economy, which often serves as a form of insurance during economic downturns. Despite this understanding, the impact of the informal economy on inflation and output dynamics in these countries remains poorly understood. This study investigates the extent to which monetary policy can stabilize economies with a large informal market. First, we use VAR analysis to provide new evidence indicating that the labor informality rate increases in response to contractionary monetary policy. Second, we explore the transmission mechanism of monetary policy through a two-sector New Keynesian (NK) model that incorporates endogenous firm entry. This analysis allows us to examine the role of informality in sectoral reallocation, inflation, and output dynamics. Our findings suggest that, under a reasonable calibration of the model, the presence of a flexible, informal sector results in a lower sacrifice ratio in response to a tightening of monetary policy. This suggests that informality enhances the effectiveness of monetary policy.

Keywords: monetary policy; business cycles; informal economy; regulatory entry costs; firm dynamics; emerging market and developing economies (search for similar items in EconPapers)
JEL-codes: E23 E26 E31 E32 O17 (search for similar items in EconPapers)
Date: 2025
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DOI: 10.1515/bejm-2025-0024

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