Informality, Frictions and Monetary Policy

Nicoletta Batini, Paul Levine (), Emanuela Lotti () and Bo Yang

No 711, School of Economics Discussion Papers from School of Economics, University of Surrey

Abstract: How does informality in emerging economies affect the conduct of monetary policy? To answer this question we construct a two-sector, formal-informal new Keynesian closed-economy. The informal sector is more labour intensive, is untaxed, has a classical labour market, faces high credit constraints in financing investment and is less visible in terms of observed output. We compare outcomes under welfare-optimal monetary policy, discretion and welfare-optimized interest-rate Taylor rules building the model in stages; first with no frictions in these two markets, then with frictions in only the formal labour market and finally with frictions on both credit markets and the formal labour market. Our main conclusions are first, labour and financial market frictions, the latter assumed to be stronger in the informal sector, cause the time-inconsistency problem to worsen. The importance of commitment therefore in- creases in economies characterized by a large informal sector with the features we have highlighted. Simple implementable optimized rules that respond only to observed aggregate inflation and formal-sector output can be significantly worse in welfare terms than their optimal counterpart, but are still far better than discretion. Simple rules that respond, if possible, to the risk premium in the formal sector result in a significant welfare improvement.

Keywords: Informal economy; emerging economies; labour market; credit market; tax policy; interest rate rules (search for similar items in EconPapers)
JEL-codes: E24 E26 E32 J65 (search for similar items in EconPapers)
Pages: 43 pages
Date: 2011-07
New Economics Papers: this item is included in nep-cba, nep-dge, nep-iue, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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Persistent link: https://EconPapers.repec.org/RePEc:sur:surrec:0711

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