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Informality, rule-of-thumb consumers, and the effectiveness of monetary policy in emerging economies

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  • Chikonda, Mtendere Chilolo
  • Chortareas, Georgios
Abstract
This paper investigates how the presence of a large fraction of rule-of-thumb consumers and an informal sector and (henceforth, informality) impact on the effectiveness of monetary policy in developing/emerging economies. We develop a small open economy New-Keynesian model, which is estimated using data on selected Sub-Saharan African countries where the coexistence of these two frictions is widespread - Burundi, Malawi and Rwanda. The results reveal that (i) rule-of-thumb consumption enhances the dominance of demand shocks and makes inflation stabilization a challenge; (ii) the presence of an informal sector causes supply shocks to be dominant, creating a trade-off between stabilizing inflation and output; (iii) rule-of-thumb consumption weakens the transmission mechanism of monetary policy while its interaction with informality worsens the situation in most of the selected countries; (iv) informality amid a large population of rule-of-thumb consumers causes the nominal interest rate to counterintuitively decline in response to a contractionary monetary policy shock; (v) in some of the selected countries, a positive productivity shock counterintuitively triggers a nominal exchange rate appreciation when informality interacts with rule-of-thumb consumption behavior; (vi) the coexistence of informality and rule-of-thumb consumption behavior amplifies country-risk premium shocks and; (vii) rule-of-thumb consumption behavior is welfare enhancing. These findings are informative to policymakers, particularly in emerging economies, on the priority reforms as they transition to inflation targeting frameworks. Direct policy implications emerge regarding financial inclusion, the size of the informal sector, and farm input subsidy programs.

Suggested Citation

  • Chikonda, Mtendere Chilolo & Chortareas, Georgios, 2024. "Informality, rule-of-thumb consumers, and the effectiveness of monetary policy in emerging economies," The Quarterly Review of Economics and Finance, Elsevier, vol. 97(C).
    • Handle: RePEc:eee:quaeco:v:97:y:2024:i:c:s1062976924000905
    DOI: 10.1016/j.qref.2024.101884
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    More about this item

    Keywords

    Informality; Rule-of-thumb consumption; Monetary policy; New Keynesian models; Welfare;
    All these keywords.

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E39 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Other
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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