Informality, labor regulation, and the business cycle

Abstract

We ask how labor regulation and informality affect 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, endogenous labor participation, and an informal sector. Our own calculations from the ENOE national household survey reveal that these three margins are important to account for the labor market dynamics in Mexico. The model is calibrated to the Mexican economy, in particular to business cycle moments for employment and informality. We show that interest rate shocks, which affect specifically job creation in the formal sector, are key to obtain a countercyclical informality rate. In our model, the presence of an informal sector might help to mitigate the impact of a stringent labor regulation on employment and consumption fluctuations. In that sense, it adds flexibility to the economy in its adjustment to shocks, but at the cost of a lower productivity and an excess TFP and output volatility. Reducing the burden of labor regulation to the formal sector might achieve the goal of reducing output volatility while improving at the same time the efficiency in the allocation of resources.