The Business Cycle Consequences of Informal Labor Markets

This dissertation explores the connection between the structure of labor markets and business cycle dynamics, with a focus on informality. The first chapter summarizes the main contributions of the dissertation. Institutional quality is one of the most important determinants of cross-country differences in informality. The second chapter analyzes the link between institutions, the size of the informal sector, and aggregate volatility. I build a business cycle search and matching model with informal labor markets that captures the positive connection between informal sector size and consumption and investment volatility in the data. In addition, I show that the root cause of changes in the size of the informal sector matters for establishing the relationship between (1) informality and long-run macroeconomic outcomes and (2) informality and aggregate volatility. For the same change in informal sector size, changes in different parameters of institutional quality in the model have contrasting quantitative implications for the steady state and the volatility of unemployment in the economy. These results highlight the importance of identifying the specific source behind changes in the size of the informal sector to characterize the link between informality and business cycle dynamics. The third chapter explores the connection between the share of self-employment in the economy and the pace of economic recoveries. Self-employment comprises an important share of employment in many countries. Recent studies document that self-employment expands during downturns, a fact that arises from higher transition rates out of unemployment and into self-employment in recessions. Furthermore, countries with higher self-employment shares exhibit lower output persistence over the business cycle. I build a novel business cycle model with frictional labor markets where individuals can be self-employed or employed in salaried firms. I show that economies with larger self-employment shares exhibit faster recoveries following a negative economy-wide productivity shock. Differences in the ease of entry into self-employment as the economy recovers play a key role in explaining contrasting labor market and output dynamics. The model successfully captures some of the key cyclical patterns of self-employment absent in existing models, as well as the quantitative relationship between self-employment and cyclical output persistence in the data

Trends in aggregate employment, hours worked per worker, and the long-run labor wedge

Hours worked are fundamentally important for aggregate economic activity, yet canonical macroeconomic models fail dramatically at tracking its long-run trends. We develop an intuitive and tractable extension of the canonical model that decomposes trend hours into extensive and intensive margins via household-side employment-attainment costs and firm-side employment adjustment costs. Its predictions track very well the trend behavior of hours, and its two underlying margins, in the United States and a host of OECD countries. Our framework is relevant for analyzing the long run labor-market effects of a number of factors such as productivity growth, and tax or labor-market reforms

Banking and Financial Participation Reforms, Labor Markets, and Financial Shocks

The degree of bank competition as well as firms’ and households’ participation in the domestic banking system differ considerably in emerging economies (EMEs) relative to advanced economies (AEs). We build a small-open-economy model with endogenous firm entry, monopolistic banks, household and firm heterogeneity in par- ticipation in the banking system, and labor search to analyze the labor market and aggregate consequences of financial participation and banking reforms in EMEs. We find that there is a pre-reform threshold of firm participation in the banking system below which reform implementation leads to sharper unemployment and aggregate fluctuations amid foreign interest rate and aggregate productivity shocks. Our find- ings suggest that comprehensive banking reforms that foster household participation and bank competition in tandem can reduce labor market and aggregate volatility, but only under a high-enough pre-reform level of firm participation in the banking system and a non-negligible increase in bank competition

Financial Development, Unemployment Volatility, and Sectoral Dynamics

We document a negative and significant relationship between domestic financial de- velopment and unemployment volatility in developing and emerging economies (DEMEs). However, there is no significant relationship between these variables in advanced economies (AEs). A labor-search model with production heterogeneity, sectoral financial frictions, and interfirm input credit can rationalize these differential cross-country results. Un- employment volatility is decreasing in financial development, but the quantitative relevance of this relationship is increasing in the extent to which input credit is prevalent in an economy. This insight is consistent with the fact that, empirically, input credit is much more prominent in DEMEs compared to AEs

Trends in aggregate employment, hours worked per worker, and the long-run labor wedge

Hours worked are fundamentally important for aggregate economic activity, yet canonical macroeconomic models fail dramatically at tracking its long-run trends. We develop an intuitive and tractable extension of the canonical model that decomposes trend hours into extensive and intensive margins via household-side employment-attainment costs and firm-side employment adjustment costs. Its predictions track very well the trend behavior of hours, and its two underlying margins, in the United States and a host of OECD countries. Our framework is relevant for analyzing the long run labor-market effects of a number of factors such as productivity growth, and tax or labor-market reforms

Global Financial Risk, Domestic Financial Access, and Unemployment Dynamics

We empirically show that after an increase in global financial risk, the response of unemployment is markedly more subdued in emerging economies (EMEs) relative to small open advanced economies (SOAEs), while the differential response of GDP and investment across the two country groups is noticeably smaller, if at all, in EMEs. A model with banking frictions, frictional unemployment, and household and firm heterogeneity in financial inclusion can help rationalize these facts. Limited financial inclusion among households is central to explaining the differ- ential response of unemployment in EMEs amid global financial risk shocks

Firm Dynamism and Housing Price Volatility

Using data for a large sample of countries, we find a robust economic and quantitatively significant positive relationship between new firm density and house price volatility. A business cycle model with endogenous firm entry, housing, and housing finance constraints successfully replicates this new fact, both qualitatively and quantitatively. Greater average firm entry is associated with higher average house prices. This makes the cost of housing loans more sensitive to housing-finance shocks, leading to sharper credit and lending-spread fluctuations, and ultimately factually-sharper house price fluctuations. We find broad empirical validation for this mechanism

Global Financial Risk, Domestic Financial Access, and Unemployment Dynamics

We empirically show that after an increase in global financial risk, the response of unemployment is markedly more subdued in emerging economies (EMEs) relative to small open advanced economies (SOAEs), while the differential response of GDP and investment across the two country groups is noticeably smaller, if at all, in EMEs. A model with banking frictions, frictional unemployment, and household and firm heterogeneity in financial inclusion can help rationalize these facts. Limited financial inclusion among households is central to explaining the differ- ential response of unemployment in EMEs amid global financial risk shocks

Unemployement Protection for Informal Workers in Latin America and the Caribbean

We use a dynamic stochastic general equilibrium search and matching model with salaried employment and informal self-employment to analyze the implications of introducing universal unemployment protection for informal workers through transfers, which are conditional on participation in training programs. We study how changes in unemployment benefits (UB) for unemployed workers in training programs (training UB), modify labor market outcomes for the unemployed. The model suggests that increasing training UB reduces unprotected unemployment and improves labor market outcomes through higher formal salaried employment and lower informal self-employment. Allowing for idiosyncratic quality in these training programs is key for these results. Higher training UB can also reduce total informal employment through a drastic reduction in the share of informal self-employment, without necessarily causing a large increase in total unemployment. Finally, the model suggests that increasing training UB may increase the volatility of unprotected unemployment. The influence of training programs on formal wage-setting is crucial to explain these results.