Abstract:
The primary objective of this paper is to investigate the interaction of formal and informal financial markets
and their impact on economic activity in quasi-emerging market economies. Using a four-sector dynamic stochastic
general equilibrium model with asymmetric information in the formal financial sector, we come up
with three fundamental findings. First, we demonstrate that formal and informal financial sector loans are
complementary in the aggregate, suggesting that an increase in the use of formal financial sector credit creates
additional productive capacity that requires more informal financial sector credit to maintain equilibrium.
Second, it is shown that interest rates in the formal and informal financial sectors do not always change
together in the same direction. We demonstrate that in some instances, interest rates in the two sectors
change in diametrically opposed directions with the implication that the informal financial sector may frustrate
monetary policy, the extent of which depends on the size of the informal financial sector. Thus, the larger
the size of the informal financial sector the lower the likely impact of monetary policy on economic
activity. Third, the model shows that the risk factor (probability of success) for both high and low risk borrowers
plays an important role in determining the magnitude by which macroeconomic indicators respond
to shocks.
