Job creation and job destruction in the presence of informal markets

In developing economies, the fraction of informal workers can be as high as 70% of total employment. For economies with significant informal sectors, business cycle fluctuations and labor market policy interventions can have important effects not only on the unemployment rate, but also on the allocation of workers across regulated and unregulated jobs. In this paper, using worker flows data from Brazil, we build, calibrate, and simulate a two-sector search and matching labor market model, in which firms have the choice of hiring workers formally or informally. We show that our model can explain well the main cyclical patterns that lead to those cyclical reallocations. We also show how the effect of government interventions in the labor market depend on the magnitude of the reallocation of labor across regulated and unregulated sectors. For our calibration, policies that decrease the cost of formal jobs, or increase the cost of informality, raise the share of formal employment while reducing unemployment.