A Bilateral Monopsony Approach to Lending, and the Hidden Economy in LDCs

A model is presented in which one firm borrows from one bank with a positive supply curve of loans. The bank monitors firm’s output, which firm produces output underground too, in order to avoid this monitoring and minimize its marginal expenditure on loans by defaulting. The model incorporates also a laborer-consumer who allocates labor between the formal and informal sectors in a way preserving full employment. In this model, the following results obtain: There cannot be underground only economy even in the absence of government national-accounting induced output monitoring once part at least of the output has to be monitored by the bank. The capital employed officially is always more than that underground. Bank monopoly power induces lexicographic preferences towards underground economy income. The stability of the system depends on the relative size of the official to total capital ratio and the response of loan demand to the interest rate. The introduction of government and indirect taxation alter the optimal official to total capital ratio. Yet, the steady-state and stability of the system remain unchanged under a tax financed balanced budget. Government borrowing by a rent-seeking government or to cope with tax-evasion induced budget deficits lowers lending to the firm and leads thereby the system to equilibrium away from steady-state; but tax evasion increases such lending towards steady-state restoration.