Informality and Shock Propagation in an Open Economy

The informal sector accounts for a large fraction of the economy and labor force in many emerging market and developing economies. This 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 rely more on formal inputs (which can be produced at home or imported) while non-traded goods rely more on informal inputs. We show that, despite its costs, the informal sector can provide a flexible margin of adjustment in labor and product markets which helps buffer the impact of domestic and external shocks.