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# The Role of Informality in Moderating the Impact of Adverse Macroeconomic Shocks

In the presence of informality, adverse demand shocks have a lower impact on aggregate output and adverse supply shocks have a lower impact on prices as well as output. Both would imply that countries without a substantial informal sector, largely more affluent nations, would be more exposed to higher prices following such shocks. This is consistent with contemporary evidence of stagflation in developed countries. Being the residual sector, the informal sector inevitably moves in the opposite direction to the formal sector during a bad shock episode, cushioning its aggregate effect. We then show that the argument goes through if the firms have to finance their working capital requirements by borrowing

from the market.

The authors are indebted to Pintu Parui for comments on an earlier version of the article.

Many theoretical studies have demonstrated that the presence of an informal economy generates a buffer effect or serves as a shock absorber that diminishes the pressure of a demand shock (Castillo and Montoro 2010; Alberola and Urrutia 2019; Lambert et al 2020). Empirical studies like, for instance, Deaton (2021) have supported these theoretical conjectures for the COVID-19 pandemic. According to Deaton (2021), the pandemic reduced per capita incomes more in higher-income countries than lower-income countries and as a result, country-by-country international income inequality decreased during the pandemic.

The objective of this article is to give a simple explanation of the phenomenon that makes these results possible. We argue that by its very essence, the informal sector is a place where all those who are forsaken by the formal sector find refuge. It is therefore a sector that is a perfect substitute for the formal sector—expanding when the former contracts and vice versa. Since the sector is productive and contributes to the GDP of a country, its function is to moderate the effects of shocks to the formal sector. This happens both for positive and negative shocks hitting an economy. Thus, the presence of the sector reduces the pace of progress and decelerates the rate of decline of GDP after a negative shock hits the country.

The main intuition of the article is that underdeveloped countries have a productive fallback option for workers during times of stress. This makes them more resilient to negative shocks than those who do not have this option. In these (developed) countries, workers who are released by the formal sector during the recession are plunged into unproductive open unemployment increasing the impact on their aggregate GDP. By natural extension, the intuition takes us to the conclusion that the extent of the cushioning effect will decline as the productivity of alternative employment declines due to overcrowding in the informal sector. Thus, the magnitude of the cushioning effect declines with the magnitude of the shock. This is exactly where our model takes us.

**The Model**

We start from a standard aggregate demand (AD) function:

Y_{D}=Y_{D} (r,P) … (1)

For this article, we will assume *r* to be the target rate of interest of the central bank in line with the new classical and new Keynesian micro-foundations. The main intervention is in the realm of aggregate supply. Let *Y _{S}* denote the aggregate supply, part of which comes from the formal sector

*Y*, and the other from the informal sector

_{FS}*Y*. We assume that both these sectors produce final goods.

_{IS}*Y*hires

_{FS}*L*workers at a minimum wage

_{F}*.*

__w__*Y*hires

_{IS}*L*at a labour market clearing wage rate

_{I}*w*where

*w <*. If

__w__*w*is higher than

*, then it is a case of labour scarcity, that is, at*

__w__*there is excess demand for labour which is assumed away. Workers opt for a job in the informal sector if they do not find one in the formal sector at a lower marketing clearing wage (Carruth and Oswald 1981; Agenor and Montiel 1995; Marjit 2003; Marjit and Kar 2011). This implies:*

__w__L_{F }+ L_{I }= L … (2)

Also, we have the sectoral profit maximisation conditions:

… (3)

… (4)

where *W* is the flexible informal wage that ensures full employment. Given (__w__*, **p*), equation (3) determines *L _{F}** and equation (4) determines

*w**, the informal wage. We do not explicitly bring in capital in this section. Capital is assumed to move freely between the two sectors.

Therefore, the aggregate supply is given by

… (5)

Where:

… (6)

Equating equations (1) and (5), we get the goods market clearing condition:

Y_{d}=Y_{S} … (7)

The slope of the aggregate supply curve can be determined by differentiating (5) with respect to *P*.

… (8)

Since , our result

shows that if we do not have an informal sector, other things being the same, *Y _{s }*will respond more to a given change in price. The simple idea is that where

*p*increases, more workers are hired in the formal sector at a given

*. If we have an informal sector, workers come from the informal sector and*

__w__*Y*declines.

_{IS}*Y*has two opposing effects since

_{S}

__w__*>*

*w*, ,

but less than without the informal sector.

This is demonstrated graphically in Figures 1 and 2. In both figures, *Y _{SI}* is the supply curve with the informal sector and

*Y*is the supply curve without the informal sector. As noted above, for a given price change, the output change is more without the informal sector and hence,

_{SF}*Y*is flatter than

_{SF}*Y*. If the recession is caused by a negative demand shock (demand curve moves from

_{SI}*Y*to

_{d}*Y’*) as in Figure 1, output falls to

_{d}*Y*

^{*}

*without the informal sector but to*

_{SF}*Y*

^{*}

_{S}*with the informal sector. On the other hand, for an equivalent amount of negative supply shock AB in Figure 2, the economy faces a more severe stagflation (it shrinks more and prices rise more) if the informal sector is not there.*

_{I}**Updated On : 30th Jan, 2024**