The Government Spending Multiplier in the Presence of the Informal Sector

Abstract

In a small open economy framework that features properties of the informal sector, I examine the relationship between this sector and the size of the government spending multiplier. I show that countries with relatively larger shares of this sector in their production are more inclined to generating smaller multipliers. In the presence of the informal sector, the marginal cost, inflation and the real interest rate respond more strongly to the rise in government spending compared to that of an economy without this sector. This leads to a larger fall in private consumption. The resultant multiplier is therefore smaller. In a liquidity trap period however, the amplifying effects of the informal sector on inflation leads to a larger multiplier compared to that of the economy without this sector. These findings suggest that the informal sector could be one of the major driving forces behind the relatively smaller multipliers in low-income countries (most of which are characterized by significantly large shares of this sector in their output).