The Informal Sector and the Welfare Effects of Inflation Targeting

In a quantitative framework featuring the informal sector, I show that, first, following a demand shock, inflation and the output gap are significantly more volatile in the presence of this sector than without it. For a supply shock however, I find that, while the informal sector amplifies volatility in the output gap, it has the opposite effect on inflation. Secondly, the presence of this sector increases the sacrifice ratio of monetary policy, thereby raising the output cost of stabilizing inflation. In this environment, targeting domestic inflation is the most effective policy in lowering the welfare cost of demand and supply shocks.