cost to participate in the formal sector and so they have smaller participation rates. In
those countries, the effects of technological shocks are amplified.
Cavalcanti and Villamil (2003) in a dynamic model with a household sector show how
the Friedman rule of zero inflation is not optimal in countries with a large informal sector
(labour, good or financial markets). In their model, individuals allocate time between
consumption and labour in the formal or informal sector. The main idea is that if gov-
ernment’s ability to tax in the labour and commodity markets is limited, an inflation tax
decreases those distorsions. The efficacy of monetary policy in a framework where part
of the economy is not observable (i.e the informal sector) is analyzed within a DSGE
framework in Batini et al. (2009) and will be discussed in section 6.3.
In section 2 we show evidence in support of the idea that self-employed and informal
workers are mainly concentrated in non tradables (Brazil 92%, Colombia 87% and Mexico
83%). Fiess et al. (2006) and Loyaza and Rigolini (2006) develop two macroeconomic
models to investigate the nature of the informal sector. The former looks at the behavior
of the informal sector during a business cycle as a reaction to temporary and permanent
macroeconomic shocks. The latter studies the evolution of the steady-state and the cyclical
behavior of the informal sector (i.e. the long-run trends and cycles as the title suggests)
by modelling the intersectoral margins for the firm.
Fiess et al. (2006) model a formal (salaried tradable) sector and an informal (self-
employment non-tradable) sector in a Rogoff-Obstfeld small economy with the aim to
capture the sector origin of the shock through variation in the real exchange rate. What
are the drivers of large wage movements? A part from the origin of the shock, wage rigidi-
ties can explain the cyclical behavior of the informal sector. As discussed in section 2, the
informal sector does not seem to simply behave in a way to absorb shocks during nega-
tive shocks and recessions. The informal sector in the paper is characterized, a part from
self-employment, by credit constraints and a different technology. All workers are homo-
geneous when salaried workers, while they produce in proportion to their entrepreneurial
capability when informal self-employed. The model includes an occupational choice where
the marginal individual is indifferent between salaried work and self-employment. Finally,
the authors introduce potential wage rigidities in the formal salaried sector. The com-
movement of relative sector sizes are analyzed and the authors show how there is evidence
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