Optimal monetary policy under the presence of informality

Abstract

This thesis studies the optimal monetary policy in an informal sector framework in the presence of nominal price stickiness. We study the optimal policy as a Ramsey plan in which the policy makers maximizes the agent’s welfare subject to equilibrium conditions and the assumed monetary policy rule, nominal interest rate rule. Optimality conditions imply positive rate of inflation in the long run. In the presence of nominal rigidities, we showed that positive rate of inflation facilitates price adjustments and affects the efficiency of the price system. Each firm may reset its price in any given period. The optimal price for a firm depends on mark-up, real marginal cost, money stock and real marginal adjustment cost. Moreover, in each period, a firm observes its technology shock and decides in which sector to produce. In such an environment, we show that there exists a threshold technology level such that firms having a productivity below(above) this level chose to operate in the informal(formal) sector. In this setting, the monetary authority has incentives to use monetary policy to induce firms into the formal sector. The positive rate of inflation might increase the number of firms in the formal sector which leads to higher aggregate activity, but eventually the effect dies out, because positive inflation, at the same time, decreases the labor demand and gives firm an incentive to adjust their prices that is, however, a costly process.