Economic fluctuations and the shadow economy: a global study

Abstract

The recent economic crisis re-emphasizes the importance of the economic fluctuations. This study investigates the role of shadow economy in combination with economic factors on the economic instability for 133 economies between 1991 and 2015. Using the system-GMM estimations, this paper shows that a larger shadow economy increases the fluctuations of GDP growth rate in relation to the size and the volatility of shadow economy. Notably, the shadow economy presents an inverted-U relationship with economic instability and this relationship is strongest for low- and lower-middle income economies. Our results identify two categories of drivers for economic fluctuations: the stabilizing factors (the labor force and the TFP) and the enhancing factors (capital investment, consumption, government spending, trade, and FDI inflows). Interestingly, exports increase economic fluctuations while imports decrease them. Finally, we discuss the differences in the determinants of economic instability across low, middle and high incomes countries. This study documented that shadow economy influences the economic fluctuations - our results actually confirm our hypothesis and the impact of shadow economy on the effectiveness of macroeconomic policies. The contribution of this paper is to show the extent to which the impact can affect the economic activities and how institutions can smooth this effect.