International factor mobility, informal interest rate and capital market imperfection: A general equilibrium analysis ?

a r t i c l e i n f o JEL classification: D42 F21 F22 O17 Keywords: Informal credit Formal credit Moneylender Foreign capital Emigration General equilibrium This paper makes an attempt to provide a theory of determination of interest rate in the informal credit market in a less developed economy in terms of a three-sector static deterministic general equilibrium model. There are two informal sectors which obtain production loans from a monopolistic moneylender and employ labour from the informal labour market. On the other hand, the formal sector employs labour at an institutionally fixed wage rate and takes loans from the competitive formal credit market. We show that an inflow of foreign capital and/or an emigration of labour raises (lowers) the informal (formal) interest rate but lowers the competitive wage rate in the informal labour market when the informal manufacturing sector is more capital-intensive vis-à-vis the informal agricultural sector. International factor mobility, therefore, raises the degrees of distortions in both the factor markets in this case. There exists financial dualism in less developed countries (LDCs) like India, Pakistan, Bangladesh etc. with two different credit markets — formal credit market consisting of banks, cooperatives etc. and informal credit market consisting of professional moneylenders, traders, landlords etc. The formal credit market is competitive and supplies credit to the organized production sectors of the economy at relatively low rates of interest. On the contrary, the informal credit market is characterized by high degrees of imperfection and is found to be the major source of credit to the unorganized production sectors like agriculture, urban informal sectors etc. Professional moneylenders, having local monopolistic power, charge exorbitantly high rates of interest 1 to their borrowers. The theoretical literature dealing with the interaction between the formal credit market and informal credit market consists of two groups. interaction between the two credit markets in the presence of corruption in the loan delivery system in the formal credit market. Rent-seeking behaviour of the formal lender lowers the availability of formal credit and thus a demand for informal credit is created. consider vertical linkages between the two credit markets. Here informal sector lenders act as financial intermediaries between the formal credit agency and the final borrowers of credit. However, models belonging to this literature are built in static one period partial equilibrium framework and deal with a pure agrarian economy. Hence these models neither can focus on the …