Fiscal and Monetary Policy in the Presence of Informality and the Incentive to Join a Currency Union

How does economic activity outside of government control-informality-affect the conduct of fiscal and monetary policy? I study this question in a New Keynesian, small open economy model. The model is assumed to feature informality in both goods and labor markets. A non-traded sector produces a non-taxed informal good. The traded sector produces a formal good and is subject to taxation, but it can hire workers using both formal and informal contracts. I show that the presence of informality decreases the optimal tax rate and increases macroeconomic volatility. Moreover, when the country cannot credibly pre-commit to the optimal policy, informality significantly increases the incentive to peg the currency. This result can help explain why many sub-Saharan African countries have plans to either expand existing currency unions or to form new ones