Nonlinear effects of public debt on inflation. Does the size of the shadow economy matter?

•We analyse the nonlinear effects of public debt on inflation in 22 emerging countries.•We estimate a panel smooth transition regression to evaluate the time-varying coefficient of public debt.•We provide evidence that the shadow economy acts like a threshold variable regarding the explanation of the inflation dynamics.•A higher level of public debt appears to increase inflation if the shadow economy exceeds a certain threshold.•Countries with large informal sectors are more vulnerable and less able to raise the level of public indebtedness to cope with the effects of a shock, such as the COVID-19 pandemic. This paper explores the nonlinear effects of public debt on inflation. Using a sample of 22 emerging economies, our results provide evidence regarding the existence of threshold effects between inflation and public debt. Specifically, we find that emerging countries with a relatively low shadow economy can accommodate increases in public debt without the additional welfare costs that are associated with higher inflation. In contrast, those countries where the shadow economy exceeds 24.3% of GDP face greater macroeconomic costs in terms of inflation. Consequently, they have less room for manoeuvre when dealing with the effects of the COVID-19 pandemic