We examine the role of labor informality in shaping macroeconomic volatility in a small open economy. Using a DSGE model calibrated to Colombia, we focus on worker-level rather than firm-level informality. The model features heterogeneous households and a segmented labor market with formal and informal workers, incorporating wage rigidities and productivity differences. Our results show that higher informality amplifies the volatility of consumption and investment, which is consistent with the empirical evidence. The mechanism operates through the interaction of wage rigidities in the formal sector with lower productivity of informal workers. Quantitatively, the model accounts for a significant share of the observed link between informality and volatility. These findings highlight how labor market frictions magnify business cycle fluctuations in emerging economies.
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Approach
This document examines the impact of labor informality on macroeconomic volatility in a small open economy, drawing on the Colombian case. First, it conducts an empirical exercise using data from 60 countries to identify stylized facts linking informality to aggregate volatility and to access to financial markets. Based on this evidence, it develops a DSGE model featuring heterogeneous households, a segmented labor market with differentiated wage rigidities, and productivity gaps across sectors. The model is then used to assess shortterm macroeconomic dynamics and to perform counterfactual simulations under different levels of informality.
Contribution
The document addresses the apparent paradox of labor informality: although it acts as a buffer for employment and labormarket dynamics, it also amplifies macroeconomic volatility. In contrast with previous studies focusing on informality at the firm level, this paper introduces an analytical framework based on heterogeneous households, where labor supply is segmented between skilled and unskilled workers. The model jointly incorporates wage rigidities, financial exclusion, and productivity differentials. As a result, it captures households’ ability to substitute between formal and informal employment and shows how these frictions shape the transmission channels of macroeconomic shocks.
“Labor informality, through its interaction with wage rigidities, productivity differences, and household financial constraints, acts as a powerful amplifier of macroeconomic volatility in consumption and investment, despite its traditional role as an employment stabilizer in emerging economies.”
Results
The results indicate that higher informality increases the volatility of consumption and investment, in line with international empirical evidence and in contrast with the traditional view that considers it an employment stabilizer. This effect stems from wage rigidities in the formal sector, which induce adjustments in labor demand and in household income.
At the same time, financial exclusion limits informal workers’ ability to smooth consumption, thereby amplifying fluctuations in aggregate demand. Quantitatively, the model accounts for 36% of the relationship between informality and consumption volatility, and 60% of the relationship in the case of investment. Finally, although informality mitigates employment volatility by absorbing workers displaced from the formal sector, it increases inflation volatility, with direct implications for the transmission of monetary policy.