Informal Labour and Credit Markets: A Survey.

to a monetary policy shock as well as the impact on the inflation rate.²⁷ In general there
is a rapidly growing literature on search matching labour market in New Keynesian DSGE
models in addition to Ravenna and Walsh (2007). Christiano et al. (2007) and Thomas
(2008) introduce labour market frictions in New Keynesian models allowing the study of,
both, the intensive and the extensive margin of labour usage during the business cycle.
Blanchard and Gali (2007) adopt a simpler hiring cost approach in a New Keynesian
framework.

Castillo and Montoro (2008) develop Blanchard and Gali (2007) by modelling a dual
labour market economy with formal and informal labour contracts within a New Keynesian
model with labour market frictions. This is the first paper that analyzes together the
creation of informal jobs and the interaction between the informal sector and monetary
policy. Informality is a result of hiring costs, which are a function of the ratio of vacancies
to unemployment (labour market tightness). In equilibrium, firms in the wholesale sectors
balance the higher productivity of a formal production process with the lower hiring costs
of the informal process. Marginal costs will then become a function also of the proportion
of informal jobs in the economy. The interesting results of this theoretical framework is
that during period of high aggregate demand the informal sector expands due to lower
hiring costs associated with this technology. This creates a link between informality, the
dynamics of inflation and the transmission mechanism of monetary policy. In particular,
the authors show that “informal workers act as a buffer stock of labour that allows firms
to expand output without putting pressure on wages”.

Batini et al. (2009) adopt a similar approach by modelling the presence of an ‘unob-
servable’ classical labour market together with a wage norm to summarize frictions in the
formal sector. This allows a general equilibrium analysis which is more in the Harris and
Todaro tradition (Harris and Todaro, 1970) and the study of the link between inflation and
unemployment. The authors conclude that the benefits from reducing the informal sector
- i.e. tax smoothing and net benefits from stabilization with tax smoothing - outweigh
the cost in terms of less wage flexibility.

²⁷See Yasgiv (2007) for a survey on the developments of search-matching models and (Ravenna and
Walsh (2007)) for a recent application of search frictions in New Keynesiam models.

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