Monetary Policy and Informal Labor Markets

A predominant share of employment in EMDEs is in the informal sector. In 2019-2020, approximately 72% of total employment was in the informal sector in India, with casual employment comprising 22% and self-employment comprising 50%. How does informality in labor markets affect inflation stabilization and monetary policy setting? To address this, we build a medium-scale NK-DSGE model with segmented labor markets and search and matching frictions. We calibrate the model to India. As in the data, we divide informal employment into self-employment and casual employment. We show that more formality improves the transmission of monetary policy. We show that a contractionary monetary policy shock leads to a decline in both formal and informal employment (self and casual), suggesting that monetary policy’s impact on output and inflation works through informal labor markets as well. Our paper highlights the mechanism behind the transmission of monetary policy in the presence of heterogeneous labor markets.