Macroeconomic volatility: The role of the informal economy

- Small open economy model where one sector is formal and the other sector is informal.
- I explore the effect that the informal sector has on measured business cycles.
- If the informal sector is poorly measured, consumption is more volatile than output.
- Consistent with evidence from many developing and some developed countries.

Many countries have a large informal economy that is poorly measured in the national accounts. I develop a two-sector small open economy business cycle model where one sector is formal and the other is informal, and explore the effect that the informal sector has on measured business cycles. I show that if the informal economy is poorly measured, the model can generate a volatility of measured consumption that is higher than that of output, as observed in many developing countries and some developed countries, even though actual consumption is not nearly as volatile. My results illustrate the importance of the informal sector and its mis-measurement in understanding measured cyclical fluctuations.