Shadow economies at times of banking crises: Empirics and theory

This paper investigates the response of the shadow economy to banking crises. Our empirical analysis, based on a large sample of countries, suggests that the informal sector is a powerful buffer, which expands at times of banking crises and absorbs a large proportion of the fall in official output. To rationalise our evidence, we build a dynamic stochastic general equilibrium model which accounts for financial and labour market frictions and for nominal rigidities. In line with the empirical literature on the shadow economy, we assume that in the informal sector access to external finance is limited, and the production technology is relatively more labour intensive. Following a banking shock in the official sector, the model predicts a large negative transmission to the unofficial economy that substantially dampens the overall effect of the shock.