The primary objective of this paper is to investigate the interaction of formal and
informal .nancial 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 .nancial sector, we come up with three
fundamental .ndings. First, we demonstrate that formal and informal .nancial sector
loans are complementary in the aggregate, suggesting that an increase in the use of
formal .nancial sector credit creates additional productive capacity that requires more
informal .nancial sector credit to maintain equilibrium. Second, it is shown that
interest rates in the formal and informal .nancial 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 .nancial sector may frustrate monetary policy, the extent of which depends
on the size of the informal .nancial sector. Thus, the larger the size of the informal
.nancial 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.
Key words: Informal .nancial sector, formal .nancial sector, monetary policy, gen-
eral equilibrium