Monetary and Fiscal Policy in the Presence of Informal Labour Markets

NIPFP Working Paper 97
[PDF]

Nicoletta Batini, Paul Levine, Emanuela Lotti and Bo Yang
November 2011

Abstract

How does informality in emerging economies affect the conduct of monetary and fiscal policy? To answer this question we construct a two-sector, formal-informal new Keynesian closed-economy. The informal sector is more labour intensive, is untaxed, has a classical labour market, faces high credit constraints in financing investment and is less visible in terms of observed output. We compare outcomes under welfare-optimal monetary policy, discretion and welfare-optimized interest-rate Taylor rules alongside a balanced-budget fiscal regime. We compare the model, first with no frictions in these two markets, then with frictions in only the formal labour market and finally with frictions on both credit markets and the formal labour market. Our main conclusions are first, labour and financial market frictions, the latter assumed to be stronger in the informal sector, cause the time-inconsistency problem to worsen. The importance of commitment therefore increases in economies characterized by a large informal sector with the features we have highlighted. Simple implementable optimized rules that respond only to observed aggregate inflation and formal-sector output can be significantly worse in welfare terms than their optimal counterpart, but are still far better than discretion. Simple rules that respond, if possible, to the risk premium in the formal sector result in a significant welfare improvement.

Monetary and Fiscal Policy in a DSGE Model of India

NIPFP Working Paper 96
[PDF]

Paul Levine and Joseph Pearlman
November 2011

Abstract

We develop a optimal rules-based interpretation of the ‘three pillars macroeconomic policy framework’: a combination of a freely floating exchange rate, an explicit target for inflation, and a mechanism than ensures a stable government debt-GDP ratio around a specified long run. We show how such monetary-fiscal rules need to be adjusted to accommodate specific features of emerging market economies. The model takes the form of two-blocs, a DSGE emerging small open economy interacting with the rest of the world and features, in particular, financial frictions. It is calibrated using India and US data. Alongside the optimal Ramsey policy benchmark, we model the three pillars as simple monetary and fiscal rules including and both domestic and CPI inflation targeting interest rate rules. A comparison with a fixed exchange rate regime is made. We find that domestic inflation targeting is superior to partially or implicitly (through a CPI inflation target) or fully attempting to stabilizing the exchange rate. Financial frictions require fiscal policy to play a bigger role and lead to an increase in the costs associated with simple rules as opposed to the fully optimal policy. These policy prescriptions contrast with the monetary-fiscal policy stance of the Indian authorities.

An Estimated DSGE Model of the Indian Economy

NIPFP Working Paper 95
[PDF]

Vasco Gabriel, Paul Levine, Joseph Pearlman and Bo Yang
November 2011

Abstract

We develop a closed-economy DSGE model of the Indian economy and estimate it by Bayesian Maximum Likelihood methods using Dynare. We build up in stages to a model with a number of features important for emerging economies in general and the Indian economy in particular: a large proportion of credit-constrained consumers, a financial accelerator facing domestic firms seeking to finance their investment, and an informal sector. The simulation properties of the estimated model are examined under a generalized inflation targeting Taylor-type interest rate rule with forward and backward-looking components. We find that, in terms of model posterior probabilities and standard moments criteria, inclusion of the above financial frictions and an informal sector significantly improves the model fit.

Informal Labour and Credit Markets: A Survey

NIPFP Working Paper 94
[PDF]

Nicoletta Batini, Young-Bae Kim, Paul Levine and Emanuela Lotti
November 2011

Abstract

This paper reviews the literature on the informal economy, focusing first on empirical findings and then on existing approaches to modelling informality within both partial and general equilibrium environments. We concentrate on labour and credit markets, since these tend to be most affected by informality. The phenomenon is particularly important in emerging and other developing economies, given their high degrees of informal labour and financial services and the implications these have for the effectiveness of macroeconomic policy. We emphasize the need for dynamic general equilibrium (DGE) and ultimately dynamic stochastic general equilibrium (DSGE) models for a full understanding of the costs, benefits and policy implications of informality. The survey shows that the literature on informality is quite patchy, and that there are several unexplored areas left for research.

Millenium Development Goals: How is India Doing?

NIPFP Working Paper 93
[PDF]

Sudipto Mundle
November 2011

Growth and Election Outcomes in a Developing Country

NIPFP Working Paper 92
[PDF]

Poonam Gupta and Arvind Panagariya
October 2011

Abstract

With the exception Brander and Drazen (2008), who use a comprehensive cross-country database consisting of both developed and developing countries, the hypothesis that rapid growth helps incumbents win elections has been tested exclusively for the developed countries (e.g., Ray Fair 1978). But since sustained rapid growth offers the prospect of pulling vast numbers of the voters out of poverty within a generation, such an effect is far more likely to be present in the developing rather than developed countries. In this paper, we offer the first test of the hypothesis on a large developing and poor country, India, which has seen its economy grow 8 to 9 percent recently. We first generalize the Fair model to allow for multiple candidates instead for just two and then test it using cross-state data. We find quantitatively large and statistically robust effect of growth on the prospects of the candidates of the state incumbent parties to win elections. Specifically, we use the data on 422 candidates in the 2009 parliamentary elections and show that the candidates of incumbent parties in high-growth states have much better prospects of victory than those in low-growth states.