Unemployment dynamics with informality: An empirical analysis for a developing country

We implement decompositions of cyclical unemployment in a large developing country using the conventional 3-states and a 4-states representation of the labor market, where in the latter we subdivide the employment state into formal and informal forms of employment. This allows a richer analysis of the dynamics of unemployment that unveils the role played by the inflows and outflows from and into the formal and informal sectors. Results for the 3-states representation show that job separation play a much larger role than job finding, a result that differs from what is found for the U.S. The 4-states decomposition unveils that the contribution of the flow from informality to unemployment is larger than that of the flow from formal jobs. This evinces that job separations from the informal sector do play a role in explaining variations in the unemployment rate along the cycle. Opposite results are revealed for the job finding rate, where the formal sector displays a much larger contribution than the informal sector. We also compare the model performance of the 3- and 4-states representations and show that for many indicators the latter is superior to the former.