Labor Market Informality and the Business Cycle

43 Pages Posted: 5 Jan 2021

See all articles by Frederic Lambert

Frederic Lambert

International Monetary Fund (IMF)

Andreas Pescatori

International Monetary Fund (IMF)

Frederik Toscani

International Monetary Fund

Date Written: November 1, 2020

Abstract

Labor market informality is a pervasive feature of most developing economies. Motivated by the empirical regularity that the labor informality rate falls with GDP per capita, both at business cycle frequency and in a cross-section of countries, and that the Okun's coefficient falls with the level of labor informality, we build a small open-economy dynamic stochastic general equilibrium model with two sectors, formal and informal, which can replicate these key stylized facts. The model is calibrated to Colombia. The results show that labor market and tax reforms play an important role in changing the informality rate but also caution against over-optimism - with low GDP per capita, informality will always be relatively high as there is insufficient demand for formal goods. Quantitatively we find that higher productivity in the formal sector is key in explaining the difference between Colombia and countries with significantly lower informality. We use the model to study how labor informality and labor market frictions mediate the cyclical response of the economy to shocks, including commodity price shocks which are particularly relevant in Latin America. Informality is shown to play an important role as a shock absorber with the informal-formal margin limiting movements in the employed-unemployed margin.

JEL Classification: E26, E32, J20, D24, J01, E30, J64

Suggested Citation

Lambert, Frederic and Pescatori, Andreas and Toscani, Frederik, Labor Market Informality and the Business Cycle (November 1, 2020). IMF Working Paper No. 20/256, Available at SSRN: https://ssrn.com/abstract=3758090

Frederic Lambert (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Andreas Pescatori

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Frederik Toscani

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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