Optimal Monetary Policy in the Presence of Sizable Informal Sector and Firm Level Credit Constraint

Optimality of pro-cyclical monetary policy in the presence of informal sector and firm level constraint is analysed. The findings suggest that in case of export demand shock pro-cyclical monetary policy suits only when shock is severe and domestic firms have high leverage ratio. However, the conventional monetary policy helps cushioning the loss in output when the size of informal sector is significantly large. Furthermore, fixing exchange rate is better policy option if objective is to keep domestic employment or consumption from falling (when negative shock hits the economy). Any disproportionate impact of monetary policy on informal sector is not found. This may be due to static nature of the model and it might be possible that dynamics of responses of the two sectors to shocks differ significantly.