Informal labor market, inflation and monetary policy

Aniello Piscopo

No 569, Working Papers from University of Milano-Bicocca, Department of Economics

Abstract: Informality represents a pervasive feature of many emerging and developing economies, yet standard macroeconomic models often ignore its effects, potentially biasing the analysis of shocks and the design of monetary policy. This paper studies the macroeconomic and policy implications of informality using a structural VAR for Colombia and a two-agent New Keynesian model with formal and informal sectors, featuring heterogeneous households including hand-to-mouth consumers. I show that informal labor supply shocks generate sectoral reallocation: informal activity absorbs part of the shock, sustaining aggregate output while altering wages, hours, and capital allocation. In contrast, monetary policy shocks propagate more strongly when informality is present, amplifying distributional and capital-reallocation effects. Critically, the presence of informality alters equilibrium determinacy: standard Taylor rules may fail to ensure uniqueness, with stability depending on the share of Ricardian households, the size of the informal sector, and the monetary policy stance. My findings highlight that accounting for informal production is essential for understanding transmission mechanisms and designing effective policy in economies with significant informality.

Keywords: Informal economy; Tax evasion; Monetary policy transmission; Fiscal policy; Public debt; DSGE model; Capital reallocation; Colombia (search for similar items in EconPapers)
JEL-codes: E26 E52 E62 H26 O17 O54 (search for similar items in EconPapers)
Pages: 53
Date: 2026-02
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