Public expenditure multipliers and informality

Abstract

This paper investigates the role of informality in affecting the magnitude of the public expenditure multiplier in a panel of 142 countries, using the local projections method. We find a strong negative relationship between the degree of informality and the size of the multiplier. This result holds irrespective of the level of economic development and institutional quality and is robust to additional country characteristics such as trade and financial openness and exchange rate regime. In a two-sector New-Keynesian model, we rationalize this result by showing that fiscal shocks raise the relative price of official goods, thereby shifting demand towards the informal sector. This reallocation effect increases with the level of informality, because a larger informal sector is associated with a stronger appreciation of relative prices in response to fiscal shocks, and thus reduces the multiplier.