This paper studies the implications of informality for the long run Phillips curve in developing economies. I develop a dynamic general equilibrium model with informality in both labor and goods markets and where money is mostly used in informal transactions. I show that both unemployment and the demand for money are increasing in the relative size of informal activities. Monetary policy that increases inflation affects unemployment through two channels: On the one hand, higher inflation reduces the surplus of monetary trades which lowers firms’ entry and increases unemployment. On the other hand, it shifts firms hiring decision from high separation informal jobs to low separation formal jobs which reduces unemployment. I calibrate the model to the Brazilian economy and find that inflation has a small impact on unemployment while generating significant labor reallocation from informal to formal jobs. These results imply that the informal sector dampens the long run effects of monetary policy on unemployment. They also point to the importance of accounting for informality in the conduct of monetary policy in developing economies.
A Model of Endogenous Financial Inclusion: Implications for Inequality and Monetary Policy, with Pedro Gomis-Porqueras
We propose a model of incomplete markets and endogenous credit market participation to study the impact of financial inclusion on welfare and inequality. We find that the measure of financially included agents is non-monotonic in inflation and the idiosyncratic consumption risk. In addition, consumption inequality between financially included and excluded agents, together with competitive pricing in the anonymous goods market, generate a pecuniary externality. We show that overconsumption of financially included agents can exist and it is increasing with inflation and decreasing with consumption risk. We propose various policies that can alleviate this inefficiency. Finally, we conduct a quantitative assessment for the case of India. We show that a direct benefit transfer scheme to bank users can reduce consumption inequality and increase welfare even when consumption decreases.