Growth effects of inflation under the presence of informality

Abstract

In this paper we study the interrelationship between growth, size of the informal economy and inflation. We build an endogenous growth model in which the informal economy is subject to a cash-in-advance constraint along with physical capital and consumption. In this setting, we find that inflation adversely affects long-term growth. However; this effect strongly interacts with informality. Specifically, it becomes milder (and can even be positive) in the presence of a large informal economy. Moreover, using an annual cross-country panel data set of 161 countries over the period 1950 – 2009, we also provide strong empirical support for the mechanism of our theory.