Informal self-employment and macroeconomic fluctuations

Abstract

Informal self-employment is a major source of employment in developing countries. Its cyclical behavior is important to our understanding of the functioning of LDC labor markets, but turns out to be surprisingly complex. We develop a flexible model with two sectors: a formal salaried (tradable) sector that may be affected by wage rigidities, and an informal (non tradable) self-employment sector faced with liquidity constraints to entry. This labor market is then embedded in a standard small economy macro model. We show that different types of shocks interact with different institutional contexts to produce distinct patterns of comovement between key variables of the model: relative salaried/self-employed incomes, relative salaried/self-employed sector sizes and the real exchange rate. Model predictions are then tested empirically for Argentina, Brazil, Colombia and Mexico. We confirm episodes where the expansion of informal self-employment is consistent with the traditional segmentation views of informality. However, we also identify episodes where informal self-employment behaves “pro-cyclically”; here, informality is driven by relative demand or productivity shocks to the non tradable sector.