Previous theoretical and empirical works have focused on the impact of an enlarging informal sector on growth. This paper shows that the size of the informal economy also affects business cycles volatility. Informal businesses are usually small in size, which prevents them from achieving economies of scale, from operating with the right capital/labor mix, and from having access to credit markets. This lack of access to credit markets hinders informal firms' ability to neutralize the cash flow squeeze arising during recessions, increasing their exposure to fluctuations in economic activity and their likelihood of going bankrupt. Using a Generalized Method of Moments methodology on a cross-country dataset, this paper shows that the larger the informal sector of a country, the greater the volatility experienced in output, investment and consumption over the business cycles.
business cycles; informal sector; legal institutions
