this reduces the consumption further and shifts the demand for labour back somewhat.
The latter two effects cancel out the direct demand effect for model II and dominates for
model III. This is driven by the quite small differences in the policy rules for models II and
III which result in a tighter stance for model III, a higher real interest rate change and a
sharp fall in consumption of Ricardian consumers. Hours worked and the real wage fall in
the formal sector. There is now an important terms of trade effect. The concentration of
the demand shock in the formal sector causes the relative rise of its output to rise, shifting
demand to the informal sector. This squeezes investment (which comes entirely from the
formal sector) further and it falls significantly more than in one-sector models I and II.
The monetary shock IRFs can largely be explained in terms of the different estimated
rules. The positive shock to the nominal interest rate drives down inflation. In the more
aggressive Taylor rules in models II and III this triggers a compensating strong downward
adjustment to the interest rate, which now hardly moves from its steady state. The real
interest rate in model I stays positive for several periods, diverging sharply from the other
two models. Investment and Tobin’s Q consequently fall. Consumption and investment
demand are lower in model III and therefore output is as well. Since investment is formed
entirely from the output of the formal sector, there is a shift in demand away from the
formal sector and its terms of trade (the relative price Pt in the figure) falls.
The price mark-up shock (in the formal sector for model III) perhaps produces the
most interesting IRFs, in that they differ significantly across all three models. For all three
models a positive price mark-up shock lowers demand for output (in the informal sector for
the case of model III) and demand for labour shift inwards. The real wage falls and with it
the marginal cost, offsetting the original shock. Monetary policy is contractionary in model
I: both the nominal and real interest rate rises in response to the rise in the inflation rate,
pushing the consumption of Ricardian households down, reducing investment and causing
Tobin’s Q to fall. In model II the fall in the real wage results in a drop in the consumption
on non-Ricardian households, reducing demand for labour further and adding to the output
fall. The marginal cost fall further offsetting the original inflation shock, so now inflation
falls resulting now in a expansionary monetary response; both the nominal and real interest
rate rises, now raising investment and causing Tobin’s Q to rise. In model III the informal
sector acts as a buffer, absorbing workers who are no longer employed in the formal sector
and this dampens the output, consumption and hours worked effects seen in models I and
II. The CPI inflation rate now includes informal sector inflation, which is directly affected
by the shock. The monetary stance therefore lies between those for models I and II as do
the investment and Tobin’s Q paths.
A common risk premium shock in both sectors directly increases the cost of capital
and this is amplified by the financial accelerator. Investment, output and Tobin’s Q all
fall. The demand for labour curve shifts inwards and hours worked fall. In model I the
monetary stance is on average over 10 periods slightly contractionary, so Ricardian house-
holds save less and consume more. The more aggressive rules for models II and III see a
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