An Empirical Equilibrium Model of Formal and Informal Credit Markets in Developing Countries

Abstract

I develop and estimate a dynamic equilibrium model of risky entrepreneurs’ borrowing and savings decisions incorporating both formal and local-informal credit markets. Households have access to an exogenous formal credit market and to an informal credit market in which the interest rate is endogenously determined by the local demand and supply of credit. I estimate the model via Simulated Maximum Likelihood using Thai village data during an episode of formal credit market expansion. My estimates suggest that a 49 percent reduction in fixed costs increased the proportion of households borrowing formally by 36 percent, and that a doubling of the collateralized borrowing limits lowered informal interest rates by 24 percent. I find that more productive households benefited from the policies that expanded borrowing access, but less productive households lost in terms of welfare due to diminished savings opportunities. Gains are overall smaller than would be predicted by models that do not consider the informal credit market.