Money, Inflation, and Unemployment in the Presence of Informality

Abstract

This paper studies the implications of informality for the long run relationship between inflation, output and unemployment in developing economies. I present a monetary dynamic general equilibrium model with search frictions in both labor and goods markets and where informality is an equilibrium outcome. Policies that lead to a larger informal sector result in an upward shift in both the money demand relation and the Beveridge curve. In contrast, financial development reduces informality and shifts both the Beveridge curve and the money demand relation downwards. An increase in the long run inflation rate affects unemployment through two channels: On the one hand, higher inflation reduces the surplus of monetary trades which lowers firms' profits, job creation and increases unemployment. On the other hand, it shifts firms' hiring decision from high separation and cash intensive informal jobs to low separation formal jobs which reduces unemployment. I calibrate the model to the Brazilian economy and find that the existence of a large informal sector significantly dampens the long run effects of monetary policy on unemployment and output. This result points to the importance of accounting for informality in the conduct of monetary policy in developing economies.