Does informality facilitate inflation stability?

Informality is a structural trait in emerging economies affecting the behavior of labor markets, financial access and economy-wide productivity. This paper develops a simple general equilibrium closed economy model with nominal rigidities, labor and financial frictions to analyze the transmission of shocks and of monetary policy. In the model, the informal sector provides a flexible margin of adjustment to the labor market at the cost of lower productivity. In addition, only formal sector firms have access to financing, which is instrumental in their production process. In a quantitative version of the model calibrated to Mexican data, we find that informality: (i) dampens the impact of demand and financial shocks, as well as of technology shocks specific to the formal sector, on wages and inflation, but (ii) heightens the inflationary impact of aggregate technology shocks. presence of an informal sector also increases the sacrifice ratio of monetary policy actions. From a Central Bank perspective, the results imply that informality mitigates inflation volatility for most type of shocks but makes monetary policy less effective.