Explaining cross-country differences in participation rates and aggregate fluctuations

The empirical evidence shows that there exists a negative relationship between the ratio of employment to population and the standard deviation of (log of) GDP. In this paper, we build a Real Business Cycle model with an underground economy sector in order to quantitatively address this issue. The existence of an alternative to registered market activities for providing tradeable goods and services implies that population will be switching sectors in response to aggregate productivity shocks, amplifying the response of registered output. The level of participation in registered market activities will then be negatively related to fluctuations. This feature does not arise in a standard one sector model.