entrepreneurs in the developing world are credit-constrained and a significant fraction
of credit is still in the hands of operators in the informal credit market despite the de-
velopment of a formal credit system. Ghosh et al. (1999) review the different modelling
strategies in the partial equilibrium analysis of informal credit markets. The authors point
to informal credit markets and moral hazard and limited enforceability by distinguishing:
models with involuntary and with voluntary default. The main result highlighted in the
survey is that despite the different modelling details, the models share a common view:
credit rationing appears as a rational response to information and enforceability problems
and the small firms with minimum or none collateral seem the more exposed. As far as
policy recommendations are concerned, the authors call for measures aimed at improving
the institutional environment such as improving borrowers’ bargaining power,decrease in
asset inequality etc. instead of macroeconomic policy aimed at increasing the interest
rate. Yunus and Weber (2007) contribute to the debate on the impact of microcredit on
the standard of life of the very poor. The author adopts a revolutionary approach and
look at the positive impact of informal credit on the development and standard of life
in the developing world. Microcredit, following Yunus’s definition targets the very poor,
particularly women, and it is based on trust since the lack of collateral is one of the main
limitations of borrowing from standard financial institutions.
As far as theoretical work on credit-constrained entrepreneurs and informal credit
market is concerned, firstly, we look into papers that focus on adverse selection and moral
hazard. The literature in this area clearly assumes missing markets to explain the emer-
gence of an informal credit market. Secondly, we investigate theoretical modelling with
credit constraints due to search externalities. This strand of literature only mention, with-
out explicitly models, informal credit markets. Thirdly, we review papers that model the
decision to be formal or informal by assuming the lack of access to formal finance as one
of the main cost of going informal. Finally, we move onto papers that investigate the
relationship between informal credit markets and monetary policy.
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