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

Abstract

In this paper, I develop and estimate a dynamic equilibrium model of household borrowing and savings decisions in formal and informal credit markets. The model features households with heterogeneities in productivity and wealth, and characterizes credit market access by interest rates, fixed costs, and borrowing constraints. 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. My application focuses on Thailand which implemented policies in 2001 that primarily encouraged borrowing. I estimate the model by simulated maximum likelihood using data from the Townsend Thai Monthly Survey. Based on the estimated model, I find that lower fixed costs increased the proportion of households borrowing formally, and that relaxed formal borrowing collateral constraints lowered informal interest rates. In terms of welfare, I find that low wealth but productive households benefited from Thai policies to expand credit access, but the gains were smaller than suggested by previous studies that ignored the informal market. Moreover, approximately 18% of households suffered welfare losses because of diminished opportunities for informal saving. Counterfactual policy simulations suggest that policies that combine borrowing and savings subsidies could yield higher average social welfare at a cost similar to the implemented policies.