| 1 Introduction Many researchers have underscored the striking differences between the business cycles in emerging countries (henceforth EC) and in developed countries (henceforth DC).1 More precisely, in EC the relative volatility of consumption to output is larger than one, net exports are substantially more countercyclical, and EC also exhibit countercyclical real interest rates that lead the cycle. Simultaneously, the size of the informal economy, defined as currently unregistered economic activities contributing to country’s output, is on average significantly larger in EC than in DC.2 This paper aims to assess the contribution of the informal economy and interest rate fluctuations to the behavior of the business cycles in EC. The main contributions of this paper are twofold. First, the paper documents the importance of the informal economy and fluctuations in country interest rate. I show that there is a positive relationship between the size of the informal economy and relative volatility of consumption to output even after accounting for the fluctuations during global financial crisis.3 Furthermore, I provide evidence on the countercyclicality and large fluctuations of interest rates in EC.4 The interest rates in the DC are shown to lag the cycle and to be mildly procyclical. Second, I construct a theoretical model that is calibrated to match the features of Argentine and Mexican business cycles. I find that the model captures several key empirical moments that are usually difficult to replicate in international macroeconomics literature including a relative volatility of consumption to output in excess of one and a countercyclical trade balance-to-output ratio. The theoretical framework consists of a small open economy model with a formal and an informal sector. The source of uncertainty is sector-specific technology shocks and exogenous fluctuations in country spread. Household chooses to work in the informal sector, which does not pay taxes, and to work in the formal sector, which uses both capital and labor to produceformal goods. Formal sector firms register with the government and hence have access to international markets, where they borrow at an international interest rate to pay a fraction of their wage bill in advance. Informal sector firms use informal labor to produce informal consumption goods. Formal consumption goods can be traded across countries, since the government registers the activity of only formal firms. |