Job Creation and Job Destruction in the Presence of Informal Labor Markets

Recessions and policy interventions in labour markets in developing countries arecharacterized not only by changes in the unemployment rate, but also by changesin the proportion of formal or protected jobs. This reallocation between formal andinformal jobs is large and occurs mainly because the job nding rate of formal jobs reacts substantially more than the job nding rate of informal jobs. This paper presents a search and matching model to capture this fact. I assume that there is a distribution of productivities of potential matches and that rms choose to legalize only those matches that are good enough to compensate the costs of formality. In this framework, recessions or stricter regulations in the labour market trigger two e¤ects. As expected, they lower the incentives to post vacancies (meeting effect), but also affect the frims'hiring standards, favouring informal contracts (o¤er e¤ect). This new channel shedslight on how the actions of policy makers alter the outcomes in an economy withinformal jobs. For instance, attempts to protect employment by increasing ring costswill reallocate workers to informal jobs, where job separation is high. They are alsolikely to increase unemployment.