Informality, Labor Regulation, and the Business Cycle

Abstract

We analyze the joint impact of employment protection and informality on macroeconomic volatility and the propagation of shocks in emerging economies. For this, we propose a small open economy business cycle model with frictional labor markets, labor regulation, and an informal sector, modeled as self-employment. The model is calibrated to the Mexican economy, in particular to business cycle moments for employment and informality obtained from our own calculations with the ENOE survey for the period 2005-2016. We show that international interest rate shocks, which affect specifically job creation in the formal sector, are key to obtain a counter-cyclical informality rate. In our model both the economy without an informal sector and the economy with informality but a lower burden of labor regulation feature higher volatility in employment but smaller fluctuations in TFP and output.

Does informality facilitate inflation stability?

“…We introduce a simple monetary model for a closed economy. The real side of the model, adapted from Leyva and Urrutia (2018), features both formal and informal sectors, labor market frictions and an endogenous participation in the labor force decision. A representative family can choose to spend part of its time endowment working in the formal sector or the informal sector, searching for formal jobs as unemployed or out of the labor force.…”

“…5 Our modeling of informal employment is akin to models of self-employment or home production, in which there are no frictions to entry or exit into/from these activities. The assumption is meant to capture the flexibility of the informal sector, in which there are no explicit contracts and the duration of jobs is much shorter than in the formal sector (see Leyva and Urrutia (2018)).…”

“…A period in the model is a quarter. Some of the parameters are based on the related work of Leyva and Urrutia (2018) or correspond to standard values in the literature.…”

“…Because the productivity of the informal sector is typically low, changes in the composition of workers during a recession can amplify changes in TFP. In two recent papers, Leyva and Urrutia (2018) and Horvath (2018) stress the role of interest rate shocks to small open economies to account for the observed cyclical properties of employment and the informality rate. We borrow from Leyva and Urrutia (2018) the main setup for the real side of the economy, adding a working capital constraint for formal firms as in Horvath (2018) and nominal rigidities.…”

The limits to robust monetary policy in a small open economy with learning agents

“…For the robustness check, we use for the calibration: a positive pass-through of the exchange rate to core inflation, φ = 0.006, in the Mexican economy for the period 2001-2015 (Banco de México 2016), it requires that σ = 1.667 that gives forσ = 0.78349, η = 3.2 according to Leyva and Urrutia (2018), ω = 0.53, δ = −0.123 and ζ = 0.25 following López-Martín (2019), ϑ = 0.85 from Klenow and Malin (2010), and κ = 0.017 from its definition using the previous calibrations. 25 Table 2 shows us the lower-bound thresholds of θ π ,θ x ,θ e reflecting the maximum level of CB's focus in favor for robustness in the Mexican economy, varying with the learning gain γ.…”