By Gaetano Lisi
Relying on the non-negligible role played by the underground economy in the labour market fluctuations, this paper extends the standard matching model à la Mortensen-Pissarides by introducing an underground sector along with an endogenous sector choice for both entrepreneurs and workers. These modifications improve the quantitative properties of the standard matching model, thus providing a possible explanation for the unemployment volatility puzzle.
It is too often forgotten that a substantial part of economic activity is not recorded. While home production has been considered in business cycle models, the underground economy has not. This paper shows that it matters, even when you limit yourself to observing outcomes in the visible economy.