The Underground Economy in a Matching Model of Endogenous Growth

A matching model will explain both unemployment and economic growth by considering the underground sector. Three problems can thus be simultaneously accounted for: (i) the persistence of underground economy, (ii) the ambiguous relationships between underground employment and unemployment, and (iii) between growth and unemployment. Key assumptions are that entrepreneurial ability is heterogeneous, skill accumulation determines productivity growth, job-seekers choose whether to invest in education. The conclusions are that the least able entrepreneurs set up underground firms, employ unskilled labour, and do not contribute to growth. Underground employment alleviates unemployment only if the monitoring rate is sufficiently low.