The AD-AS Model with the Shadow Economy

This theoretical paper includes the shadow economy in the popular AD-AS model and derives the main economic results for both the short-run and the long-run. This accounts for the presence of the shadow economy in countries around the world, as well its persistence over time. Precisely, if the shadow economy is capable of absorbing unemployment, then in the short-run there will be a supply-side positive shock on output (the “shadow shock”). The “shadow shock” is, however, temporary; in the long-run the effect of the shadow economy on potential output is negative.