thus promote capital accumulation and growth when credit markets are segmented and
lower income households are credit constrained and thus, can only access informal credit
markets. The monetary and fiscal policy implications for keeping rural interest rates low
is illustrated in Ghatak (2007): Once farmers have higher real income, they will raise their
repayments, reducing the risk premium and thus the interest rate. Measures to raise real
income suggested include low inflation as well as increasing agricultural output through
rural innovation. In this scenario, inflation not only reduces farmers’ real income but
also moneylenders’ real value of repayments, inducing higher interest rates which, in turn,
compensates for non-performing loans.
On the other hand, McKinnon (1973) and Shaw (1973) emphasize the importance
that funds remain market-determined and are not rationed as a consequence of interest
rate interventions (e.g. administratively-enforced caps) because this promotes the accu-
mulation of money balances which, in their view, are complements and not substitutes of
physical capital. Financial regulation restraining real interest rates as well as other forms
of selective credit control could reduce savings and investment while perversely enhancing
segmentation of financial markets. Therefore, these scholars argue that policies of financial
liberalization that free real interest rates in formal credit markets can increase savings and
capital accumulation (see e.g. Fry (1978)) with benefits for borrowers of all income levels.
One criticisms of this view can be found in Taylor (1983) and van Wijnb ergen (1982),
who maintain that if interest payments account for a large proportion of total production
costs, aggressive financial liberalization ending up in strong increases in borrowing costs
by low income producers could well lower overall output, and divert credit away from in-
formal markets into formal banking sectors, thereby raising further informal interest rates,
and reducing informal borrowing and investment by lower income agents (Thornton and
Poudyal (1990) and Ghatak and Chandio (2009)).
6 General Equilibrium models of informality
Although many recognize the importance of modelling informal behavior within general
equilibrium set ups (e.g.Satchi and Temple (2009), Marjit and Kar (2008) Sinha (2005)
and Zenou (2008)) most general equilibrium search matching models either incorporate
ad hoc representations of informality or assume it away altogether. For example, stan-
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