Shadow Economies at Times of Banking Crises: Empirics and Theory

Abstract

This paper investigates the response of the shadow economy to banking crises. Our empirical analysis, based on a large sample of countries, suggests that the informal sector is a powerful buffer, which expands at times of banking crises and absorbs a large proportion of the fall in official output. To rationalise our evidence, we build a dynamic stochastic general equilibrium model which accounts for financial frictions and nominal rigidities. In line with the empirical literature on the shadow economy, we assume that in the informal sector access to external finance is limited, and the production tech- nology is relatively more labour intensive. Following a banking shock in the official sector, the model predicts a large negative transmission to the unofficial economy: about 60% of the official sector contraction is absorbed by the growth of the shadow economy.