Revisiting the Relationship between Unemployment Rates and Shadow Economy. A Toda-Yamamoto Approach for the Case of Romania

Shadow economy(SE) is a controversial topic that has aroused the interest of the specialists from the 60's, when the phenomenon took a great extent. Formed in the literature under various names, the shadow economy exists in a more or less extent in all countries, regardless of their level of development, enjoying an enduring existence, although as area of research is a new “young” area. The paper aims to investigate the relationship between the size of the shadow economy (SE) and the registered and ILO unemployment rates for the case of Romanian data using Toda-Yamamoto approach for quarterly data covering the period 2000-2010. The size of the Romanian shadow economy based on the currency demand approach was estimated using multivariate cointegration and vector error correction models (VECM) in order to investigate whether a long-run equilibrium relationship exists between currency demand and its determinants. In order to investigate the relationship between the unemployment rates and the size of the shadow economy for the case of Romania we use an innovative econometric methodology to study the direction of causality between the two variables, namely Toda and Yamamoto (1995). According to Giles and Tedds(2002), two opposing forces determine the relationship between unemployment and the informal economy. On the one hand, an increase in the unemployment rate may involve a decrease in the informal economy because it is positively related to the growth rate of GDP and eventually negatively correlated with unemployment (Okun's law). On the other hand, increase in unemployment leads to an increase in people working in the informal economy because they have more time for such activities. Dell’Anno and Solomon (2007) stated that there is a positive relationship in the short-run between unemployment rate and U.S. shadow economy for the period 1970-2004. Using SVAR analysis, they investigate the response of the shadow economy to an aggregate supply shock (impact of the shadow economy to a temporary shock in unemployment). The empirical results show that in the short-run, a positive aggregate supply shock causes the shadow economy to rise by about 8% above the baseline. According to the Toda-Yamamoto causality test results, there is strong evidence of causality running from the registered and ILO unemployment rates to the shadow economy when a sufficiently high lag order is selected.