Macroeconomic effects of fiscal policy in the presence of the informal sector: a DSGE analysis

Purpose This study aims to construct a New Keynesian DSGE model by incorporating the informal sector with a rich set of fiscal instruments to examine the effects of different fiscal policy stimuli on key macroeconomic variables in the presence of an informal economy. Based on the constructed model, the authors also assess the role of the informal sector in determining the size of fiscal policy multipliers. Design/methodology/approach This paper considers informality in labor and goods markets. Although the study’s objective is to provide a general DSGE framework for analyzing the impact of fiscal policy shocks, we calibrated most of the parameters by focusing on Pakistan’s economy. Findings The results show that government expenditure shocks increase the output of both formal and informal sectors. It implies that increased government expenditure, when financed through higher taxes, might have unintended consequences in economies with a significant informal sector, such as increased informality. However, the size of the informal economy shrinks due to a decrease in labor and capital income tax rates. The results also indicate that higher labor mobility amplifies the impacts of fiscal policy shocks, implying that the policies aimed at reducing labor market rigidities and addressing skills disparities between formal and informal labor can enhance the effectiveness of cuts in labor and capital income taxes in reducing the size of the informal economy. Originality/value This study is the first attempt to analyze the impact of fiscal policy shocks by introducing a rich set of fiscal instruments into the New Keynesian DSGE model with informal labor and goods markets. Moreover, the authors attempt to analyze the role of labor market mobility in conditioning the impact of different fiscal policy shocks on the cyclical behavior of informal and formal sectors of the economy.