Journal of Money Laundering Control

IS – LM model revisited in the perspective of underground economy

Debasish Roy,
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IS – LM model revisited in the Perspective of

underground
perspective of underground economy

economy
Debasish Roy 311
Department of Management, Sikkim University, Gangtok, India

Abstract
Purpose – The purpose of this paper is to review the investment-savings, liquidity-money (IS–LM) model
used in the traditional macroeconomic theory as an important tool to analyze the dynamics of product and
money market. The IS curve represents product market equilibrium condition and the LM curve represents
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money market equilibrium condition. However, the traditional IS–LM model was formulated mainly keeping
in mind the dynamics of the product and money markets of developed economies. Thus, there was an urgent
need to explore the pre-established IS–LM model in the light of existing enormous, illicit underground
economies prevalent all around the world.
Design/methodology/approach – In this paper, an exploratory attempt has been made to review the
IS–LM model in the light of various illicit practices and by incorporating some assumptions that are relevant
to this discussion. In this model, ISil curve could be defined as a locus of points each representing a combination
of evaded tax and output of the illicit economy that will keep the illicit economy in equilibrium and, the LMil
curve could be defined as a locus of points each representing a combination of illicit supply of money and
output of the illicit economy that will keep the illicit economy in equilibrium.
Findings – This paper is aimed at analyzing the traditional IS–LM model from a different perspective,
namely, the pervasive underground economy thriving all around the world regardless of the stages of growth
and development. A sincere attempt has been made to keep the assumptions simple and closest to the
real-world scenario as well as pertinent to the logic of economic theory. In this paper, two major factors of illicit
practices, i.e. tax evasion and bribery, are given prime importance and the discussion is focused on those two
factors of corruption.
Originality/value – This paper has been prepared keeping in view the standard technical procedures and
findings that are described in the relevant academic materials like textbooks and journal publications
(mentioned under the “References” column). The analysis and findings appearing in the article are based on
logical explanations and are completely free from plagiarism.
Keywords Demand for illicit money, Illicit economy, ISil curve, LMil curve, Supply of illicit money
Paper type Conceptual paper

Introduction
As the term “illicit” or “underground” economy consists of various types of malpractices
such as bribery, tax evasion, grafting, there was an initial predicament of either choosing a
“single most” important index of corruption or simply club the various forms into a
composite variable. In this paper, the “tax evasion” factor has been chosen as the suitable
variable of corruption or illicit practices keeping in mind the enormous amount of illicit
money being stashed at the “tax havens” like Swiss Bank, Channel Island, Cayman Islands
etc. from all over the world every year. According to a paper published by Internal Revenue Journal of Money Laundering
Service (IRS) of USA Treasury on “Abusive Offshore Tax Avoidance Schemes – Talking Control
Vol. 20 No. 3, 2017
points during 2008”, it is estimated that some US$$5tn in assets are held “offshore” in tax pp. 311-319
havens and, according to one authority’s estimate, the annual revenue loss to the USA is a © Emerald Publishing Limited
1368-5201
minimum of US$70bn[1]. DOI 10.1108/JMLC-08-2016-0039
 JMLC The above statistics clearly explain the objective of choosing the “tax evasion” factor as
20,3 the suitable variable of illicit practices, although clubbing of the other forms of malpractices
into a single factor (variable) would also suffice for our purpose.

Literature review
One of the major difficulties the economists face is to formulate a precise definition of
312 underground or shadow economy. One commonly used definition states that it comprises of
all currently unregistered economic activities that would contribute to the officially
calculated GNP if the activities were registered[2]. Dell’ Anno (2003) has broadly defined
shadow economy as “those economic activities and the income derived from them that
circumvent or otherwise avoid government regulation, taxation and observation”. The
measurement of shadow economy is based on the following four criteria:
(1) to avoid income taxes, value added or other taxes;
(2) to avoid contributions to social insurance schemes;
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(3) to avoid meeting certain specific labor market standards like minimum wages,
maximum working hours, safety standards, etc.; and
(4) to avoid complying with certain administrative obligations.

The appropriate methodology for measuring the volume of shadow economy is quite
difficult because of the very nature of such an economy. Generally, three methods are applied
to measure the volume of shadow economy:
(1) time-constrained survey method;
(2) use of macroeconomic indicators to proxy the development of the shadow economy
overtime; and
(3) use of statistical or econometrical modeling to estimate the shadow economy as an
“unobserved” or “latent” variable.

The most commonly used measurement is based on a combination of the multiple indicator
multiple cause (MIMIC) method and the currency demand method. The MIMIC procedure
formally treats shadow economy as an unobserved or latent variable that can be estimated
quantitatively as well as the indicators of illicit activities. A major disadvantage of MIMIC
method is that it produces only relative sizes and developments of the shadow economies. In
order to calibrate the relative values into absolute values (as a percentage of the national
income), the currency demand method is used. Table I shows the MIMIC statistical results for
twenty-one highly developed OECD (Organization for Economic Cooperation and
Development) countries for the time period 1990-1991 to 2006-2007, and we can follow that
the shares of social security contribution and direct taxation play the most significant roles
in shadow economy, followed by tax morale and quality of state institutions.
Figure 1 shows that in 2014, the median European country was Spain, having a shadow
economy of 18.5 per cent of its GDP, whereas Bulgaria peaked with 31 per cent of its GDP as
shadow economy. Figure 2 shows that within the time span of 1999-2007, 116 developing
countries and 25 countries in transition to market economy enjoyed greater shares of shadow
economies (as percentage of their GDPs) compared to 25 OECD countries and 162 countries
worldwide. However, the common factor that may be deducted from the two figures is that
the countries in transition experience greater shares of shadow economy as a percentage of
the GDP.
 Cause variables Estimated coefficients
Perspective of
underground
Share of direct taxation (in % of GDP) 0.392*** (3.34) economy
Share of indirect taxation (in % of GDP) 0.184* (1.74)
Share of social security contribution (in % of GDP) 0.523*** (3.90)
Burden of state regulation (index of labor market regulation, Heritage
Foundation, 1: least regular, 5: most regular) 0.226* (2.03)
Quality of state institutions (rule of law, World Bank, ⫺3: worst case, ⫹3 313
best case) ⫺0.314** (⫺2.70)
Tax morale (WVS and EVS, Index, Scale tax cheating 1: always justified, 10:
never justified) ⫺0.593*** (⫺3.76)
Unemployment rate (%) 0.316*** (2.40)
Table I.
GDP per capita (in US$) ⫺0.106*** (⫺3.04) MIMIC estimation of
Indicator variables shadow economy of 21
Employment rate (in % of population 18-64) ⫺0.613*** (⫺2.52) highly developed
Average working time (per week) ⫺1.00 (residual) OECD countries for
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Annual growth rate of GDP (adjusted for the mean of all 22 OECD countries) ⫺0.281*** (⫺3.16) 1990/1991, 1994/1995,
Change in circulation of local currency per capita 0.320*** (3.80) 1997/1998, 1999/2000,
2001/2002, 2002/2003,
Notes: Further details and test statistics are available with the author; t-statistics are in 2003/2004, 2004/2005
parentheses; * , ** , *** indicate significance at the 90, 95 and 99 per cent confidence levels, respectively and 2006/2007

Figure 1.
Size of shadow
economy of 31
European countries in
2014 (as per cent of
GDP)

The model
At the beginning of the model, the terms “illicit product market” and “illicit money market”
should be defined. The illicit product market consists of production of spurious or counterfeit
products/commodities and the illicit money market comprises of demand and supply of
illegal or stashed money.
The illicit product market equation in real terms is expressed as:

yil ⫽ cil( yil ) ⫹ iil( yil ) ⫹ te (1)

 JMLC
20,3

314
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Figure 2.
Size and development
of shadow economy
for various country
groups (Per cent of
official GDP)

where yil ⫽ output in the illicit product market;

cil ⫽ aggregate consumption demand for illicit products expressed as an increasing
function of output in the illicit product market (cil= ⬍ 1);
iil ⫽ aggregate investment demand expressed as an increasing function of output in the
illicit product market (iil= ⬍ 1); and
te ⫽ gross volume of evaded tax.
Maintaining parity with the traditional LM framework, the aggregate demand for illicit
money function is divided into two parts:
(1) transactions demand for illicit money [kil (yil)]; and
(2) speculative demand for illicit money [lil (yil, te)].

The speculative demand for illicit money is expressed as a function of gross volume of
evaded tax, as it may be safely assumed that the speculative demand for holding illicit or
stashed money is positively correlated to the volume of tax evasion.
Hence, the demand for illicit money function may be expressed as (in real terms):

Mild ⫽ kil( yil ) ⫹ lil( yil te )

Thus, the equilibrium condition for illicit money market requires:

Mils ⫽ Real supply of illicit money ⫽ Mils /P ⫽ kil( yil ) ⫹ lil( yil, te ) (2)

P ⫽ price level.
Now taking total differential of equation (1), we get:
 dyil= ⫽ cil=dyil ⫹ iil=dyil ⫹ dte Perspective of
¡( 1⫺ cil= ⫺ iil= )dyil ⫽ dte (3) underground
¡dyil /dte ⫽ 1/1 ⫺ cil= ⫺ iil= ⬎ 0 economy
as cil=, iil=⬍ 1 as per assumption.
Here, the terms cil= and iil= are defined as the marginal propensity to consume illicit products
and the marginal propensity to invest in illicit markets, respectively. 315
The term |dyil/dte| is defined as the multiplier of tax evasion or fiscal multiplier of illicit
market.
It may be interpreted that the fiscal multiplier of illicit market dyil/dte ¡ ⬁ when cil=⫹
iil= ⫽ 1.
In other words, the fiscal multiplier of illicit market becomes infinite when the sum of
marginal propensities to consume illicit products and invest in illicit markets becomes unity
or 100 per cent.
Now taking total differential of equation (2), we get:
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dmilS ⫽ kil=dyil ⫹ lil=dyil ⫹ lil=dte

¡dmilS ⫽ kil=dyil ⫹ lil=dyil ⫹ lil=( 1 ⫺ cil= ⫺ iil= )dyil
(4)
¡dmilS ⫽ 关 kil= ⫹ lil= ⫹ lil=( 1 ⫺ cil= ⫺ iil= ) 兴dyil关 Since dte ⫽ ( 1 ⫺ cil= ⫺ iil= )dyil 兴
¡dyil /dmilS ⫽ 1/kil= ⫹ lil= ⫹ lil=( 1 ⫺ cil= ⫺ iil= ) ⬎ 0

as kil=, lil=⬎ 0 as per assumption.

The term |dyil/dmils| is defined as the money multiplier of illicit market.
It may be also interpreted that the money multiplier of illicit market becomes larger in
magnitude when cil=⫹ iil= ⫽ 1. Formally,

ⱍdyil/dmilsⱍcil= ⫹ iil=⫽1 ⫽ 1/kil= ⫹ lil= ⬎ ⱍdyil/dmilsⱍcil= ⫹ iil=⬍1

⫽ 1/kil= ⫹ lil= ⫹ lil=( 1 ⫺ cil= ⫺ iil= )

Hence, the term within the parentheses, i.e. (1 ⫺ cil= ⫺ iil=), may be defined as the crowding-out
factor for the illicit money market.
However, by comparing between the fiscal multiplier and money multiplier of illicit
market, it may be inferred that the former has greater impact on the expansion of output than
the latter.
Now dividing equation (3) by equation (4) gives us:

dmils /dte ⫽ ( 1/1⫺cil= ⫺ iil= ) /1/kil= ⫹ lil= ⫹ lil=( 1 ⫺ cil= ⫺ iil= )

¡dmils /dte ⫽ kil= ⫹ lil= ⫹ lil=( 1 ⫺ cil= ⫺ iil= ) / ( 1 ⫺ cil= ⫺ iil= ) (5)
¡dmils /dte ⫽ 关 kil= ⫹ lil=/1 ⫺ cil= ⫺ iil= 兴 ⫹ lil= ⬎ 0

From equation (5), it may be clearly inferred that the value of the multiplier would be low as
long as the crowding-out factor is active, i.e. as long as cil=⫹ iil=⬍ 1 (Figure 4).
When cil=⫹ iil= ⫽ 1, dmils/dte ¡ ⬁ and the effect of the crowding-out factor is nullified.
We will now try to illustrate the IS and LM curves for illicit market, termed as ISil and
LMil, respectively, in the following diagrams.
The intersection point e (Figure 3) between the ISil and ISil⬎ curves gives us the
equilibrium combination of evaded tax and output in the illicit market (te*, yil*). At optimum
 JMLC Evaded tax (te)

20,3 ISil (when cil´+ iil´< 1)

316
te* e ISil ^ (when cil´+ iil´ = 1)

Figure 3.
Derivation of optimum
levels of evaded tax Output in illicit market (yil)
and output in illicit
market yil*
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Illicit supply of

money (mils) 45° line

LMil ^ (when cil´+ iil´ = 1)

LMil (when cil´+ iil´< 1)

mil*

Figure 4.
Impacts on output and
supply of money in mil1
illicit market in
presence and absence
of crowding-out effect,
respectively yil1 yil* Output in illicit market (yil)

Evaded tax (te)

mils (when cil´+ iil´< 1)

te* x mils ^ (when cil´+ iil´ = 1)

Figure 5.
Derivation of optimum
levels of evaded tax
and money supply in
illicit market mil* Money supply in the illicit market (mils)
 evaded tax level te*, the IS curve for the illicit market becomes perfectly elastic. That is, at this Perspective of
optimum evaded tax level te*, infinite outputs in the illicit market can be produced (Figure 4). underground
The intersection point x (Figure 5) between mils and mils ⬎ curves gives us the equilibrium economy
combination of evaded tax and supply of money in the illicit market (te*, mil*). At optimum
evaded tax level te*, the money supply curve for the illicit market becomes perfectly elastic.
That is, at this optimum evaded tax level te*, infinite combinations of money supply in the
illicit market can be achieved. 317

Extension of the model with BI index (business international corruption

index)
Business International, a subsidiary of The Economist Intelligence Unit, has developed an
index of corruption based on the reports from their correspondents from more than 100
countries across the world who must grade on a scale from 0 to 10 “the degree to which
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business transactions involve corrupt payments” in each of the countries covered (“0” being
the most transparent and “10” being the most corrupt). All correspondents use the same
methodology and their reports are further checked for comparability at the regional level and
at the BI’s headquarters.
Thus, based on simple logical deduction, we have incorporated the BI index in the ISil –
LMil model by treating the investment in illicit market (iil) as a function of both yil and BI
index, as both public and private investments are exposed to corrupt payments like bribes or
“kickbacks”. We have also treated the evaded tax schedule (te) as an increasing function of BI
index, as the corrupt payments are tacit in nature and these undisclosed payments are never
shown on recipients’ annual income statements that are submitted to their respective
governments or government agencies, leading to incidents of tax evasion. Hence, higher the
BI index of a given economy, higher is the volume of tax evasion of corporate employees of
that country.
The revised product market equation with BI index may be written as:

yil ⫽ cil( yil ) ⫹ iil( yil, BI ) ⫹ te( BI ) (6)

By taking the total differential of equation (6), we get:

¡dyil⫽cil=dyil ⫹ iil=dyil ⫹ iil=dBI ⫹ te=dBI

¡( 1 ⫺ cil= ⫺ iil= )dyil ⫽ ( iil= ⫹ te= )dBI (7)
¡dyil /dBI ⫽ iil= ⫹ te=/1 ⫺ cil= ⫺ iil= ⬎ 0

As cil=, iil=, te=⬎ 0

¡dmils / 关 kil= ⫹ lil= ⫹ lil=( 1 ⫺ cil= ⫺ iil= ) 兴dBI ⫽ iil= ⫹ te=/1 ⫺ cil= ⫺ iil=
关 Since dyil ⫽ dmils /kil= ⫹ lil= ⫹ lil=( 1 ⫺ cil= ⫺ iil= )from equation: (4) 兴
(8)
¡dmils /dBI ⫽ ( iil= ⫹ te= )关 kil= ⫹ lil= ⫹ lil=( 1 ⫺ cil= ⫺ iil= ) 兴 /1 ⫺ cil ⫺ iil=
¡dmils /dBI ⫽ ( iil= ⫹ te= )( kil= ⫹ lil= ) /1 ⫺ cil= ⫺ iil= ⫹ lil=

By comparing equations (7) and (8), it may be inferred that the impact of an increase in the BI
index on the illicit money supply is greater than the impact on the output of illicit market.
 JMLC Bribery: an analysis of another vista of corruption
20,3 Apart from tax evasion, another extremely important factor of corruption regarding illicit
market discussed here is bribery. According to Olken and Pande (2012), in equilibrium, a
government bureaucrat would become corrupted if and only if the following condition holds:

W ⫺ v ⬍ (1 ⫺ p/p)(b ⫺ d) (9)
318
where W ⫽ nominal wage;
v ⫽ outside or external option;
p ⫽ probability of getting fired, if detected;
b ⫽ bribe; and
d ⫽ dishonesty cost.
Now let us consider the steady state equilibrium condition where the following condition
holds:
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Wⴱ ⫺ vⴱ ⫽ (1 ⫺ p/p)(bⴱ ⫺ dⴱ ) (10)

where W* ⫽ equilibrium wage (nominal) of the bureaucrats;

v* ⫽ equilibrium outside (external) option;
b* ⫽ equilibrium bribe; and
d* ⫽ equilibrium dishonesty cost.
The labor market equilibrium condition (for bureaucrats) requires:

Wⴱ /P ⫽ MPL

(MPL ⫽ Marginal product of labor).

¡Wⴱ ⫽ PⴱMPL ⫽ VMPL (11)

(VMPL ⫽ value of the marginal product of labor).

By substituting the value of W* from equation (10) into equation (11), we have:

vⴱ ⫹ (1 ⫺ p/p)(bⴱ ⫺ dⴱ ) ⫽ VMPL
¡(1 ⫺ p/p)(bⴱ ⫺ dⴱ ) ⫽ VMPL ⫺ vⴱ
(12)
¡bⴱ ⫺ dⴱ ⫽ (p/1 ⫺ p)( VMPL ⫺ vⴱ )
¡bⴱ ⫽ dⴱ ⫹ (p/1 ⫺ p)( VMPL ⫺ vⴱ )

From equation (12) it is evident that b* ⬎ d* ⫹ (p/1 – p) (VMPL ⫺ v*) is the sufficient but not
necessary condition for bureaucrats or any other public-sector employees, regardless of their
position, to get corrupt. Equation (12) may also be interpreted that as the marginal
productivity of the bureaucrat falls, given the value of v*, the value of the right-hand side of
the equation also falls, creating an incentive for the employee to get corrupt.
However, at VMPL⫽ v*, the employee would opt for a bribe only when it exceeds the value
of his optimum cost of dishonesty.

Conclusion
This paper is aimed at analyzing the traditional IS – LM model from the perspective of
the pervasive, illicit, underground economy thriving all around the world regardless of the
stages of growth and development. A sincere attempt has been made to keep the
 assumptions simple and closest to the real-world scenario as well as pertinent to the logic of Perspective of
economic theory. In this paper, two major factors of illicit practices, i.e. tax evasion and underground
bribery, are given prime importance and our discussion focuses on those two factors of
corruption.
economy
It may be inferred from the above discussion that the growth of the official economy
coupled with reduced unemployment and increased “formal” employment would help to
reduce the shadow economy across the globe.
319
Notes
1. www.irs.gov/businesses/small/article/0,id⫽106568,00.html
2. This definition is used by Feige (1989, 1994), Schneider (1994, 2003, 2005) and Frey and
Pommerehne (1984).

References
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Dell’ Anno, R. (2003), “Estimating the shadow economy in Italy: a structural equation approach”,
Working Paper 2003-7, Department of Economics, University of Aarhus.
Feige, E.L. (1994), The underground economy and currency enigma, Supplement to Public
Finance/Finances Publiques, pp. 119-136.
Feige, E.L. (Ed.) (1989), The underground economies. tax evasion and information distortion, Cambridge
University Press, Cambridge.
Frey, B.S. and Pommerehne, W. (1984), “The hidden economy: state and prospect for measurement”,
Review of Income and Wealth, Vol. 30 No. 1, pp. 1-23.
Olken, B.A. and Pande, R. (2012), “Corruption in developing countries”, Working Paper No. 17398, The
National Bureau of Economic Research (NBER), available at: http://economics.mit.edu/files/7589
Schneider, F. (1994), “Measuring the size and development of the shadow economy. Can the causes be
found and obstacles be overcome?”, in Brandstaetter, H. and Guth, W. (Eds), Essays on Economic
Psychology, Springer, Berlin, pp. 193-212.
Schneider, F. (2003), “Shadow economy”, in Rowley, C.K. and Schneider, F. (Eds), Encyclopedia of Public
Choice, Vol. 2, Kluwer Academic Publishers, Dordrecht, pp. 286-296.
Schneider, F. (2005), “Shadow economies around the world: what do we really know?”, European Journal
of Political Economy, Vol. 21 No. 4, pp. 598-642.

Further reading
Ades, A. and Di Tella, R. (1997), “The new economics of corruption: a survey and some new results”,
Political Studies, Vol. 55, pp. 496-515, available at: www.people.hbs.edu/rditella/papers/
pscorrsurvey.pdf
Branson, W.H. (1979), Macroeconomic theory and policy, 2nd ed., Harper & Row, New York, NY.
Schneider, F. and Williams, C.C. (2013), The shadow economy, The Institute of Economic Affairs,
London.
Schneider, F., Raczkowski, K. and Morz, B. (2015), “Shadow economy and tax evasion in the EU”,
Journal of Money Laundering Control, Vol. 18 No. 1, pp. 34-51.

Corresponding author
Debasish Roy can be contacted at: debasish2000@yahoo.com

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