Sarte (1997) that examines the effect of rent-seeking behaviors of bureaucrats on economic
growth. Sarte (1997) develops a growth model based on Romer (1990) by incorporating
both the presence of congestion in enforcing property rights and the bureaucratic rent-
seeking behaviors in regulation and taxation that limit entry into the formal sector. From
this model, it was found that such rent-seeking bureaucracies force marginal firms to move
into the informal sector even if they would face high costs of informality, leading to lower
growth of the entire economy. In the case of the low cost of informality, on the other hand,
entry conditions do not bind and a large number of firms would operate in the informal
sector. As pointed out by Nikopour et al. (2008), however, it is not surprising to have a
negative association between informality and economic growth because two growth models
reviewed above have been built on the strong assumption that the production technology
is basically determined by congestible tax-financed public services.
In contrast, Dasgupta (2005) recently develops an endogenous growth model with
informal credit markets and shows a positive effect of informality on growth. Unlike
previous studies, Dasgupta (2005) employs a dynamic general equilibrium framework in
order to resolve the endogeneity issue between financial development and growth. Similar
to those assumptions on financial markets discussed in the previous section, it is assumed
that households can borrow formally and informally and firms are heterogeneous with
different degree of risk on which banks have asymmetric information. Households are also
assumed to invest in human capital with financial costs rather than time costs. Within
the framework with the credit rationing regime that developing countries mostly take, it
is shown that informal financial markets separate the high risk firms from the low risk
ones and thus reduce the cost of credit rationing and increase the growth rates. Even
higher growth rates are expected when economies take the self revelation regime in which
banks formulate an incentive mechanism based on each firm’s self-selected demand and
set various lending rates.
6.4 New Keynesian models with informal labour markets
A series of papers incorporate the search and matching approach into DSGE models to
explain the cyclical behavior of employment, job creation and job destruction in response
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