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Interaction of Formal and Informal Financial Markets in Quasi-Emerging Market Economies

  • Harold Ngalawa


    (School of Economics and Finance, University of KwaZulu-Natal)

  • Nicola Viegi


    (Department of Economics, University of Pretoria)

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

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Paper provided by University of Pretoria, Department of Economics in its series Working Papers with number 201306.

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Length: 27 pages
Date of creation: Jan 2013
Date of revision:
Handle: RePEc:pre:wpaper:201306
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