A positive productivity shock in the formal-sector leads to the usual positive impact
on output, consumption, Tobin’s Q (the price of capital) and investment. CPI inflation
falls and, with our inflation-targeting Taylor rule in place, the nominal interest rate falls.
This looser monetary policy stance after a lag leads to a prolonged period with the real
interest rate below its steady state, so demand for consumption rises in line with supply.
There are marked differences between model I on the one hand and models II and III
with financial frictions. The latter, we recall, consist of the introduction of some credit
constrained households and a financial accelerator.
Consider the labour market and the behaviour of the real wage. With sticky prices, the
increase in demand for output is less than the 1 percent technology increase, so the demand
for labour falls shifting the demand curve in (real-wage, quantity) space inwards. This puts
an initial downward pressure on the real wage. On the supply-side of the labour market,
since the marginal utility of consumption for the household falls as consumption rises, there
is an increase in leisure (a reduction in hours) shifting the supply of labour curve outward,
thus tending to raise the real wage. With liquidity constrained households consuming out
of their wage income in models II and III, this boosts consumption and output further and
shifts the demand curve back outwards. This liquidity effect dominates and we see hours
worked stay almost at their steady state and the real wage rising in the two models with
this feature. The marginal cost (the real price of wholesale output) moves with the factor
costs: both costs of capital and labour fall in model I, but these more or less cancel out in
models II and III leaving the marginal cost almost unchanged. With informality in model
III, the positive productivity shock in the formal-sector leads to a fall in the relative price
of output in that sector (a rise in pPFt in the figure). Changes in the terms of trade between
the two sectors acts as a stabilizing cushion for investment, consumption, the real wage
and Tobin’s Q in rather the same way as the real exchange rate in a multi-country context.
This we shall see is a feature in several of the IRFs reported.
Turning to the responses to a government spending shock, the striking feature is the
presence of a ‘classical’ crowding-out effect. Indeed, the initial fiscal stimulus increases
inflation, leading to an aggressive rise in the interest rate, which provokes a fall in private
consumption and investment. This effect if significantly amplified in the presence of financial
frictions and informality. On the other hand, a shock to the policy rule implies a significant
reduction in the inflation rate, having positive real effects in terms of private investment
and output.
There are now marked differences between models I and II on the one hand and models
III with informality. Consider the labour market and the behaviour of the real wage. The
increase in demand for output leads to a corresponding increase in supply and demand for
labour - the demand for labour curve shifts outwards, putting an upward pressure on the
real wage. The crowding-out of consumption results in a fall in consumption and a rise in
its marginal utility; households reduce their leisure and increase hours shifting the supply
curve inwards and putting downward pressure on the real wage. The liquidity effect means
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