Academic journal article Economia

Institutions, Informal Labor Markets, and Business Cycle Volatility

Academic journal article Economia

Institutions, Informal Labor Markets, and Business Cycle Volatility

Article excerpt

(ProQuest: ... denotes formulae omitted.)

The informal sector, where firms and workers produce legal, market-based goods and services but circumvent government regulations, accounts for an important share of economic activity, ranging from 8 percent of GDP in some developed countries to almost 70 percent of GDP in some developing countries. The empirical literature on informality has found that institutional quality is particularly relevant in explaining cross-country differences in the size of the informal sector.1 In fact, weak institutional quality is often seen as generating higher informality.2 The existence of a large proportion of individuals and firms operating outside the official institutional framework has important implications on the speed of factor reallocation in response to fluctuations in aggregate economic conditions. On the one hand, the informal sector can act as a shock absorber during downturns.3 On the other hand, informal firms, by avoiding regulations, can swiftly adjust their inputs in response to aggregate shocks.4 Ferreira-Tiryaki provides empirical evidence suggesting that a larger informal sector is associated with higher volatility in consumption, investment, and output.5 However, the theoretical literature has ignored whether the determinants of informality-in particular, the different dimensions of institutional quality in the economy-play a role in shaping the link between informality and business cycles. While the quality of institutions appears to have a uniform effect on the size of the informal sector in the data, institutional quality can work through different channels and potentially lead to contrasting effects on aggregate economic activity. The relationship between informality and macroeconomic performance may then depend on how institutions are reflected in economic activity and whether specific sectors are affected by these institutions.6

In this paper, I explore whether the relationship between informality and aggregate volatility, with an emphasis on labor market volatility, depends on the underlying dimensions of institutional quality, which in turn affect the size of the informal sector. The aggregate effects of particular institutional differences may be difficult to disentangle in the data, since most measures of institutional quality are highly correlated with each other. This motivates the use of a simple business cycle model with frictional labor markets and informal employment, which allows me to examine the impact of different dimensions of institutional quality on informality and, in turn, the link between the informal sector and aggregate economic activity.7 In the model, I focus on two different dimensions of institutional quality that affect the size of the informal sector across economies: the economic environment in which formal firms operate, as reflected (exogenously) in the productivity of the formal sector, and the degree of enforcement of labor regulations in the informal sector.8

With regard to the economic environment, low institutional quality can lead to uncertain rules of the game pertaining to the regulations with which firms must comply.9 If firms decide to participate in the economy's institutional arrangements, this uncertainty can increase firms' costs (for example, from hiring lawyers to make sure the firm is complying with certain regulations) and also generate production bottlenecks by delaying investments and training, which all put a dent in productivity. In contrast, improvements in institutional quality can lead, for example, to better-tailored financial reforms that advance the efficiency of the formal banking system, by promoting competition that increases the quality of services offered to bank clients and, importantly, guaranteeing that the improvements fostered by the reform are carried through and maintained in a consistent fashion. Since formal firms are the ones with access to formal financial institutions, these improvements in quality and access to better services can reduce bottlenecks and increase productivity in formal firms by facilitating access to financing. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.