Firm Dynamics, Informality, and Monetary Policy
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Carlos A. Yépez
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.
Funding source: Social Sciences and Humanities Research Council of Canada
Award Identifier / Grant number: Insight Development Grant project No.56529
Funding source: University of Manitoba
Award Identifier / Grant number: URGP grant project No.55133
Acknowledgments
I want to thank Fabio Ghironi, Catalina Granda, Paulina Restrepo-Echevarria, Victoria Nuguer, Andres Fernandez, Juan Pablo Nicolini, Ivan Mendieta, Omar Licandro, anonymous reviewers, and numerous seminar participants at the World Congress of the Econometric Society 2025, Economics of Informality Conference 2024, Banco de la Republica de Colombia, Universidad ICESI, RIDGE International Macro Workshop, the Society of Economic Measurement (SEM), the 6th international workshop in Financial Markets and Non-Linear Dynamics (FMND), and the CEA meetings. I thank Lawrencia Greensdale for her research assistance. I gratefully acknowledge financial support from the Social Sciences and Humanities Research Council of Canada (SSHRC) Insight Development Grant project No. 56529, the University of Manitoba URGP grant project No. 55133, and the Faculty of Arts Research Development Fund.
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Supplementary Material
This article contains supplementary material (https://doi.org/10.1515/bejm-2025-0024).
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