Monetary and Fiscal Policy in the Presence of Informal Labour Markets

How does informality in emerging economies affect the conduct of monetary and fiscal policy? To answer this question two-sector, formal-informal new Keynesian closed-economy is constructed. The informal sector is more labour intensive, is untaxed, has a classical labour market, faces high credit constraints in financing investment and is less visible in terms of observed output. A comparison of the outcomes under welfareoptimal monetary policy, discretion and welfare-optimized interest-rate Taylor rules alongside a balanced-budget fiscal regime. The model is compared, first with no frictions in these two markets, then with frictions in only the formal labour market and finally with frictions on both credit markets and the formal labour market. [Working Paper No 97]. [http://www.nipfp.org.in/newweb/sites/default/files/wp_2011_97.pdf]