Interaction of formal and informal financial markets in quasi-emerging market economies

The primary objective of this paper is to investigate the interaction of formal and informal nancial markets and their impact on economic activity in quasi-emerging market economies. Using a four-sector dynamic stochastic general equilibrium (DSGE) model with asymmetric information in the formal \u85nancial sector, we come up with three fundamental \u85ndings. First, we demonstrate that formal and informal \u85nancial sector loans are complementary in the aggregate, suggesting that an increase in the use of formal \u85nancial sector credit creates additional productive capacity that requires more informal \u85nancial sector credit to maintain equilibrium. Second, it is shown that interest rates in the formal and informal \u85nancial 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 nancial sector may frustrate monetary policy, the extent of which depends on the size of the informal \u85nancial sector. Thus, the larger the size of the informal nancial sector the lower the likely impact of monetary policy on economic activity. Thitrd, 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.