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