Monetary policy impact on the informal economy and response to shocks in the formal economy

• Published date: 01 May 2022
• Author: Richardson Kojo Edeme,Chigozie Nelson Nkalu,Ginika Edeh
• Date: 01 May 2022
• DOI: http://doi.org/10.1002/pa.2453

ACADEMIC PAPER

Monetary policy impact on the informal economy and

response to shocks in the formal economy

Richardson Kojo Edeme

1,2

| Chigozie Nelson Nkalu

1,3

| Ginika Edeh

1

1

Department of Economics, University of

Nigeria, Nsukka, Nigeria

2

Institute of Business Research, University of

Economics, Ho Chi Minh City, Vietnam

3

Department of Economics, Aberdeen

Business School, University of Aberdeen,

Aberdeen, Scotland

Correspondence

Chigozie Nelson Nkalu, Department of

Economics, University of Nigeria, Nsukka

4100002, Nigeria.

Email: nelson.nkalu@unn.edu.ng,c.nkalu.20@

abdn.ac.uk

In developing countries, there has been a surge in the size of the informal economy

in recent years. However, the effect of monetary policy on the informal economy

and informal economy responses to shocks from the formal economy is yet to

receive empirical attention. Our study aims to explore monetary policy effect on the

informal economy and response to shocks in the formal economy in Nigeria for

48 years (1970–2018). Using Autoregressive Distributed Lag and Impulse Response

Function, we examined empirically how various monetary policy instruments affect

the informal economy and responses to shocks in the formal economy. Our result

indicates that credit to the private sector along with the exchange rate had a positive

and significant effect on the informal economy both in the long run and short run.

The estimate further indicates bank lending rate had a positive and insignificant

effect on the informal economy. Our research reveals that in the short run, the infor-

mal economy responds positively to shocks in the formal economy while the reserve

is the case in the long run. These results underscore the importance of factoring the

informal economy in monetary policy decisions.

1|INTRODUCTION

Several studies have provided convincing evidence on the positive

effect of monetary policy on economic growth and development.

Among others are Chandranath (2008), Sulaiman and Migiro (2014),

Ulaiman and Migiro (2014), Central Bank of Nigeria (2014); Nwoko,

Ihemeje, and Anumadu (2016), Nkosinathi (2019). Most recently, how-

ever, discussions have shifted to the effect of monetary policy on the

informal economy. This is occasioned by the surge in the size of infor-

mal economy which constitutes over 65% of the economy size in

some countries, yet the transmission of monetary policy which makes

up a sizable proportion of the informal economy is yet to receive

attention (Medina, Jonelis, & Cangul, 2017). In influencing the infor-

mal economy, various monetary policy instruments can be adopted.

But the most frequently used is the interest rate, which is often

adopted to control the general price level and thus, inflation. These

instruments are often introduced by the monetary authorities and the

effects trickled down to the informal sector of the economy.

A perusal of extant literature depicts that studies on the effect of

monetary policy shocks on the informal economy can be categorized

into two groups. The first category adopts restricted 2-Sector IS-LM

framework (henceforth: 2-SFM) and the second category which is

depended on the 2-Sector Monetary Business Cycle framework

(henceforth: 2-MBC). Several studies that employed the 2-SFM hold

the view that credits from monetary authorities affect the cost of bor-

rowing which is often transmitted to the informal economy. On their

part, a stronghold of the 2-SFM posits that the positive shock emanat-

ing from the cost of borrowing will contrast formal economy perfor-

mance through its influence on high-powered money. But Ononugbo

(2012) held a contrary view that such a policy tends to bustle the

informal economy. As been the experience of most developing econo-

mies, an increase in the cost of borrowing has resulted in the creation

Received: 14 August 2020 Revised: 27 August 2020 Accepted: 29 August 2020

DOI: 10.1002/pa.2453

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in any medium,

provided the original work is properly cited.

© 2020 The Authors. Journal of Public Affairs published by John Wiley & Sons Ltd.

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https://doi.org/10.1002/pa.2453