Adding an informal sector to the IS-LM framework: A graphical exposition of the IS-LM-PC-SE model for the classroom and policymaker

• Published in: Economic systems 2024-06, Vol.48 (2), p.101225, Article 101225
• Main Authors: Junior, Celso J. Costa, Garcia-Cintado, Alejandro C.
• Format: Article
• Language: English
• Subjects: Fiscal adjustments; Fiscal policy; Nonspecialists; Shadow economy; Tax evasion; Undergraduate macroeconomics
• ISSN: 0939-3625; 1878-5433
• DOI: 10.1016/j.ecosys.2024.101225

Economic policies have been shown to affect the macroeconomy in a different fashion when a sizeable shadow economy is explicitly taken into account. But, in spite of its seemingly high relevance, no intermediate-Macroeconomics textbook posits a discussion on this topic. In this paper, we seek to make a contribution by extending an otherwise conventional IS-MR-PC model along the same lines of the approach used in Blanchard’s highly acclaimed textbook (Blanchard, 2016a) to include an informal sector. We find that this two-sector model is capable of qualitatively reproducing the main basic results obtained in this literature. Therefore, importantly, this work provides a toolkit intended for undergraduate students, practitioners, policymakers, and, in general, nonspecialists on the cost-benefit analysis of economic policies in the presence of a significant underground economy. •The paper offers nonspecialists a textbook treatment on the relationship between fiscal adjustments and informality.•It resorts to an easy-to-follow IS-LM-PC model extended to include an informal sector.•This two-sector model succeeds in qualitatively replicating the main results found in the academic literature.•Expenditure-based fiscal adjustments, shifting resources from informal to market sectors, are less harmful than tax-driven ones.•It explains how tax auditing can reduce informality at the expense of economic activity.