The volatility of real GDP per capita (RGDP) in Latin American countries is significantly higher than, say, that for the United States and Canada. The same can be said about estimates of the informal sector size. Careful analysis of existing data shows two remarkable properties: first, there is a negative relationship between RGDP and informal sector size. Second, there is a positive relationship between RGDP volatility and informal sector size volatility. These features of the data allow me to make the following conjecture: in these countries, RGDP fluctuations are amplified as negative shocks trigger a movement of productive factors from the formal to the informal sector, hence lowering measured RGDP while actual RGDP (which includes both formal and informal production) is not lowered that much. This implies that actual RGDP volatility is less than measured RGDP volatility, closer to the values observed in developed economies. To test my conjecture, I build a two-sector DSGE model and ask whether a framework that allows me to measure formal and informal output can capture the real-world behavior of RGDP volatility.

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