Unemployment Dynamics and Informality in Small Open Economies

Despite the typically more pronounced aggregate fluctuations in emerging market economies (EMEs), this paper documents that EMEs exhibit a lower relative volatility and countercyclicality of unemployment rate than small open advanced economies. We link these differences to the larger informal economy in EMEs. We build a small-open-economy model that combines a formal sector featuring labor search frictions with a frictionless informal sector. A larger informal sector amplifies the impact of productivity shocks on formal output, consumption, and employment, while dampening their impact on unemployment. Varying the degree of informality explains a significant fraction of differences in unemployment dynamics across small open economies.