Informality and Shock Propagation in an Open Economy
IMF Working Papers, September 26, 2025
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- Informality and Shock Propagation in an Open Economy
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Bibliographic details
- Authors: Sandra Lizarazo, Brandon Joel Tan
- Published: September 26, 2025
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9798229024280.001
Summary
- The informal sector accounts for a large fraction of the economy and labor force in many emerging market and developing economies.
- The paper develops a dynamic stochastic general equilibrium model of a small open economy with an informal sector.
- Nominal price and wage rigidities are present in the formal sector, while prices and wages are flexible in the informal sector.
- Production of traded goods relies more on formal inputs (which can be produced at home or imported) while non-traded goods rely more on informal inputs.
- The informal sector, despite its costs, can provide a flexible margin of adjustment in labor and product markets which helps buffer the impact of domestic and external shocks.
Model and Mechanisms
- Framework: dynamic stochastic general equilibrium model of a small open economy with an explicit informal sector.
- Price and wage rigidities:
- Formal sector: nominal price and wage rigidities.
- Informal sector: prices and wages are flexible.
- Input composition:
- Traded goods: rely more on formal inputs (domestic or imported).
- Non-traded goods: rely more on informal inputs.
- Adjustment channel: the informal sector provides flexibility in labor and product markets, serving as a buffer against shocks.
Key Findings
- Informality functions as a shock absorber by permitting flexible adjustments in labor and product markets.
- The presence of an informal sector mitigates the transmission of domestic and external shocks to the formal economy.
- The trade-off: informality carries costs but delivers stabilization benefits through flexibility.
Policy Implications and Considerations
- Recognize the role of the informal sector as a flexible margin of adjustment in macroeconomic shock absorption.
- Policies aimed at formalization should consider potential trade-offs between reducing costs of informality and losing a flexible buffer against shocks.
- Design of stabilization and labor-market policies should account for differential nominal rigidities across formal and informal sectors.
Subject Areas and Keywords
- Subjects: Consumption, Inflation, Informal employment, Labor, Labor markets, National accounts, Prices
- Keywords: Caribbean, Consumption, Europe, IMF working papers, Inflation, inflation rate, Informal employment, informal sector, Informality, investment goods, Labor markets, nominal price, Shock Propagation, South Asia, Sub-Saharan Africa
Source: IMF Working Papers — "Informality and Shock Propagation in an Open Economy", Working Paper No. 2025/190, Sandra Valentina Lizarazo and Brandon Joel Tan, September 26, 2025.
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