Interactions Between Two Informal Sector Lenders and Interest Rate Determination in The Informal Credit Market: A Theoretical Analysis

The paper provides a theory of interest rates determination in the informal credit market in backward agriculture highlighting the interactions between two informal sector lenders (a professional money lender and a trader-interlocker) and explains the prevalence of different interest rates in the rural credit market. The trader and the moneylender play a non-cooperative game in choosing the extent of interlinkage and the non-interlinked informal interest rate, respectively. In the interlinked credit-product contract, the trader offers the interlockees a product price equal to the open market price and his entire surplus comes from his activities in the credit market. These results are completely opposite to those found in the existing literature on interlinkage. A price subsidy policy reduces the extent of interlinkage chosen by the trader while a credit subsidy policy may raise it. Besides, the subsidy policies unequivocally raise the non-interlinked informal interest rate of the moneylender but may lower the welfare of the farmers and the agricultural productivity. In this context, an alternative credit policy of forging a vertical linkage between the formal and informal credit markets has been considered. It has been found that a credit subsidy policy under the new system is able to raise the agricultural productivity and improve the welfare of the farmers by ameliorating their borrowing terms in the credit market.