Employment Protection, Informality, and Business Cycles in Emerging Economies

We analyze the joint impact of employment protection and informality on macroeconomic volatility and the propagation of shocks. Using Mexico as an example, we assess the extent to which a dual labor market, with a highly... [ view full abstract ]

We analyze the joint impact of employment protection and informality on macroeconomic volatility and the propagation of shocks. Using Mexico as an example, we assess the extent to which a dual labor market, with a highly regulated formal sector complemented with unregulated informal workers, replicates the outcomes of a flexible labor market in terms of business cycle properties. For this, we propose a small open economy business cycle model with frictional labor markets, employment protection and an informal sector, modeled as self-employment. The model is calibrated to the Mexican economy, in particular to business cycle moments for employment and informality obtained from our own calculations with the ENOE database. We show that interest shocks, which affect specifically job creation in the formal sector, are key to obtain a counter-cyclical informality rate. In our model, confronted with similar shocks, the economy without an informal sector features higher macroeconomic volatility. However, an economy with low levels of employment protection would experience larger volatility in employment but smaller TFP and output fluctuations.