ante homogeneous workers. Only matches with high productivity will result in formal
contracts.
5 Informal credit markets
In this section we review the different ways in which the literature has dealt with modelling
informality in credit markets instead of labour markets, in a partial equilibrium context.
Models with a frictionless labour market mainly analyze informality in terms of other
kind of imperfections. The participation to the informal economy usually implies a cost
in terms of limited access to a public good or to formal credit markets. A large informal
credit market also could have an impact on the efficacy of monetary policy, but so far
theoretical work is very limited (or missing) in this area.
As reviewed in section 2, informal moneylenders on average charge much higher interest
rates than formal interest rates due to segmented credit markets while informal interest
rates range from 0 to 200 percent par year. Relatively low interest rates in informal credit
markets (say, less than 75 per cent per year that would be on average) can be justified
by friends and family lending or multiple lending from both formal and informal financial
markets (Madestam (2009)). As explained in Hoff and Stiglitz (1990), (rural) informal
credit markets do not work neither as classical competitive markets, nor as markets where
the local moneylender has a monopoly power. The explanation of the higher interest rate
charged has normally been attributed to a lack of information. Adverse selection, moral
hazard and also imperfect enforcement require costly mechanisms such as the design of
contracts, screening process, etc. Also banks rely heavily on collateral and, by definition,
informal firms lacking of collateral, are left with one only option: borrow in the informal
credit sector. This is the case of Thailand, India and the majority of developing countries.
Ghosh et al. (1999) refers to three strands of the literature in the area of informal
credit markets: adverse selection, moral hazard and imperfect contract enforcement. In-
deed, informal credit markets have often been associated with the existence of imperfect
information in financial markets and limited enforceability. Imperfect information can
generate adverse selection, moral hazard and search externalities.
Below we look at key papers in each strand of the literature and identify some charac-
teristic modelling strategies. A common feature is that, due to a general lack of collateral,
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