Job creation and job destruction in the presence of informal labour markets

Recessions and policy interventions in labour markets in developing countries are characterized not only by changes in the unemployment rate, but also by changes in the proportion of formal or protected jobs. This reallocation between formal and informal jobs is large and occurs mainly because the job finding rate of formal jobs reacts substantially more than the job finding rate of informal jobs. This paper presents a search and matching model to capture this fact. I assume that firms operate the within firm margin of formality, choosing 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 effects. As expected, they lower the incentives to post vacancies (meeting effect), but also affect the firms' hiring standards, favouring informal contracts (offer effect). This new channel sheds light on how the actions of policy makers alter the outcomes in an economy with informal jobs. For instance, attempts to protect employment by increasing .ring costs will reallocate workers to informal jobs, where job separation is high. They are also likely to increase unemployment.