ABSTRACTA major distinguishing characteristic of most developing countries is informal credit market.The credit market dualism, that is, presence of both formal and informal credit requiresappropriate model. The purpose of this present paper is to examine macroeconomic effects ofmonetary policy in presence of credit market imperfections in general and informal creditmarket in particular. A key dimension of conduct of monetary policy is interest rate targetingby the central bank. In this paper, we construct two models under alternative exchange rateregimes: fixed exchange rate and flexible exchange rate. The model makes an attempt toexplain macroeconomic effects of different instruments of monetary policy in presence ofinformal credit market. The paper shows that financial liberalization may not be a bonanzafor an emerging market economy.JEL Classification: E, E5, F41, O16.Keywords: Credit market Dualism, Interest rate targeting, Open economy macroeconomy1. INTRODUCTION:The sole purpose of achieving macroeconomic stability requires appropriate use ofinstruments of monetary policy. It is through monetary policy that the central bankscontrol the supply of money, availability of credit and interest rate. As we shift focusfrom developed to developing nations, we notice some characteristic differencescorresponding to which we also observe differences in the use of monetary policyinstruments. In developing countries like India where a majority of the populationsuffer from the ordeals of extreme poverty, price stability is a primary concern forpolicymakers. The monetary policy regime in India has passed through a series oftransformation over the years. It was anti-inflationary during 1972-91. But since postliberalization 1991, RBI emphasized on short term and long term objectives, that is,stability of interest rate, appropriate changes in rate of interest, development ofunorganised sector and control of rising prices. While executing monetary policyReserve Bank of India (RBI) undertakes various methods of credit control.The nominal anchoring tools accessible to the policy makers to achieve this purposeare money supply targeting, exchange rate targeting and interest rate targeting.Interest rate targeting being one of the alternatives available can influence variouseconomic activities. One such under consideration is the credit market. With almostsubtlety we can say that credit is an engine for economic activities. The more theaccess to credit, the more economic activities generated. In poor rural economies,credit is an important aspect in a variety of ways. For farmers with low financialstability, credit is an important factor to finance working capital and investment infixed capital. The co-existence of different communities judged by the financial statusand possession of assets induces segregation of the credit market into the formal andinformal sector. According to surveys, a sizable share of credit market transactions inunderdeveloped countries still takes place in the informal sector, in spite ofconsiderable efforts on the government’s part to channel credit though commercialbanks. A subtle and identifiable reason behind credit market dualism is the creditrationing in the formal sector. In the words of Jaffee and Modigliani(1969 ) creditrationing refers to ‘a situation in which the demand for commercial loans exceed thesupply of these loans at the commercial loan rate quoted by the banks. From thisdefinition, a key inference drawn regards this situation as a supply side phenomenon (i.e. interest rate cannot be used as a tool to clear excess demand in the market forloans and the lender’s supply function becomes perfectly interest inelastic at somepoint). The other definition presented by Stiglitz and Weiss in their paper( 1981) takescomplete rationing out of some borrowers from the market into consideration evenwhen they are willing to pay interest exceeding the one prevailing in the market.One of the striking features of credit markets in India is the credit market dualism: theformal sector comprising credit co-operatives, regional rural banks and commercialbanks; and the informal sector having an extensive variety of lenders, viz. land lords,traders and commission agents, agricultural and professional money lenders,shopkeepers etc. Conventionally, the informal sector has been the foremost source ofrural credit in India, however, since the last two decades, with the expansion ofinstitutional banking informal sector has been dwindling continuously.According to All India Debt and Investment Survey (AIDIS), the share of informalsector in total debt of rural household decreased from 85% in 1962 to 77% in 1972and to 31% in 1982. There is a significant amount of variation in interest ratescharged by lenders of the informal credit market. The rate of interest varies fromzero percent to exorbitantly high rates of interest (Bardhan and Ruclra, 1978; Sarap,1987 Singh, 1990). Traditionally, high rates of interest have been explained in contextof opportunity cost of funds, risk premium, transaction cost and monopoly profit(Bottomley 1963, 1964; Singh 1968; Iqbal 1988). Given the unequal power relationsbetween the borrower and the lender and the personalized nature of credittransactions, the credit transactions are more complex and there is a combination offactors responsible for plurality of interest rates.In our paper, we develop an open economy model with credit rationing to study therelation between formal interest rate in credit market and domestic output level. Wehave established this relationship using both fixed and flexible exchange rates. Thepaper is organised as follows: In section 2, we offer a brief literature review. Insection 3, we setup an open economy model with informal credit market. In section 4,we carry out certain comparative static exercises. In section 5, we introduce anotheropen economy model under flexible exchange rate regime. Section 6 concludes thepaper.2. REVIEW OF LITERATURE:The literature on monetary policy is copious. In what follows, we undertake a selectreview of literature relevant to the present paper.To begin with, we consider the work of Bernanke and Mishkin (1997) which exploreshow the approach of inflation targeting has been implemented in practise. Theyargued that it is a broad framework for policy, which allows the central bank”constrained discretion”, rather than an ironclad policy rule in the Friedman sense.Though they could not offer any final conclusion on whether inflation targeting willprove to be fad or a trend but is has a number of advantages, including more coherentand transparent policy-making 1 . Ghosh, Mookherjee and Ray (1999) in their workexamined the reasons behind why a significant fraction of credit transactions in underdeveloped and developing countries still take place in the informal sector, despiteserious government efforts to channel credit by regulating commercial banks ordirectly via its own banks. In this paper, they have constructed two models. The firstmodel incorporates the adverse income or wealth shocks that make borrowers repaytheir loans. The second model whereas focuses on the problems with contractenforcement; borrowers may not repay their loans even if they have the means to doso. In spite of the differences in the two theories of credit rationing explained above,they pointed out a number of similar broad aspects. Firstly, both the model illustratesthe positive effect of higher repayment burdens on default risk. Moreover, restrictions1 We will assume in our model that the nominal interest rate is fixed by the central bank.on repayment burdens occurs due to limiting default risks which can be achieved bylimiting the size of the loan below what borrowers desire and by preventing theinterest rates from rising to extremely high levels. Secondly, credit accessibility isrestricted for the poor due to their inability to provide collateral. Collateral reducesdefault risk and exposure of the lender in the event of default. An issuecharacteristically examined in dynamic extensions of the models illustrated here is theexisting poverty and wealth inequalities.In this context the work of Mahajan, Saha and Singh (2014) is worth mentioning. Thepaper examines the appropriateness of inflation targeting for a developing economylike India. One of the leading challenges in the present framework of global economiccrisis is the debate whether priority should be rendered to inflation targeting orfinancial stability. In India, there is still another aspect, that is, which of the multipleprice indices would be most apposite for fixing as an anchor of inflation targeting. Intheir paper, they also assess different forms of Cost Price Index, Whole Sale PriceIndex and Producer Price Index in order to find which amongst them would be thebest indicator of inflation in the Indian context. Analysing the current conditionsprevailing in India, the paper validates why inflation targeting would not be an aptpolicy for India at this stage, and endorses definite changes in the presentmultivariable methodology that would make it more operative.In this context, the work of Epstein and Yelden (2008) is worth mentioning. Thepaper examines the possible alternatives to inflation targeting central bank policies tocontribute to the task of scheming a more socially optimal macroeconomic policy inorder to promote employment, improved income distribution and sustained growth.The paper argued that present day convention of central bank to keep inflation rate inlow single digits is neither optimal nor desirable. This convention is based onnumerous false premises: firstly, that inflation, at any level, has high costs; secondly,that the economies will certainly perform best in a low inflation scenario and inspecific will generate high levels of economic growth and employment opportunities;and thirdly, that there are no possible alternatives to “inflation-focused” monetarypolicy.Nkusu (2003) examines the effect of interest rates and inflation on investment andbank loans using a framework that resembles the financial sectors existing in mostlow-income developing countries. In the paper, a simple general equilibrium modelhas been setup with rationing in the market for bank loans. The model highlights thesignificance of promoting macroeconomic stability and upgrading institutions andinformational infrastructure. An important finding of the paper is that changes ininflation or interest rates not only affect investment through bank loans but there isalso an extra impact attributable to portfolio shifts.Another significant outcome of thepaper is that there is an opposite impact of lending and deposit on either investment orbank credit. The results from a policy perspective suggest that, although both thelending and deposit rates are determinants of investment, raising them does not have asignificant impact on it.Stiglitz (1990) has explained the reasons behind the successful financial performanceof the Grameen Bank of Bangladesh. He has pointed out peer monitoring as one of themajor contributing factors behind this. To justify his point of argument, in his paper,he has constructed a simple model of peer monitoring in a competitive credit marketand has suggested some of the ingredients in the design of a successful peermonitoring system.Batini, Kim, Levine, Lotti (2011) illustrated a relationship between informal labourand credit market. By carrying out certain empirical findings, they have shown howlabour and credit market affected the informal sector of an economy. Later on, in theirpaper, they have emphasized on the need for dynamic general equilibrium (DGE) andultimately dynamic stochastic general equilibrium (DSGE) models for a completeunderstanding of the cost, benefits and policy implications for informality.Birthal and Singh (1993) in their works have pointed out the co-existence of theformal and informal credit sources and their corresponding contribution in lending.They have conducted a survey in Mirzapur and Varanasi district in Uttar Pradesh,India and concluded that there exist a wide variety of tangible and intangiblecollateral in the formal sector.Our paper differs from these above stated articles in several aspects. The primaryfocus of our paper is to establish a relation between interest rate targeting in formalsector and its consequences in informal credit market and output of the economy. Wehave constructed two open economy AD-AS model with informal credit market. Atfirst, we have assumed that the exchange rate is fixed and later on we have relaxedour assumption to observe the notable changes under flexible exchange rate regime.3. The Model:We construct a simple model with informal credit market.However, it is to be notedthat many simplifying assumptions are needed to construct a proper conceptual modelto identify the working of various mechanisms.Firstly, labour is a variable factor ofproduction whereas capital is constant. Secondly, money wage is the only factorpayment considered here. Thirdly, in both factor and commodity market perfectcompetition prevails. Fourthly, factor payment is made before realization of sales andhence credit is needed to finance working capital. Fifthly, nominal wage is fixed.In this model, first we consider the reason behind the existence of informal creditmarket in developing countries. We point out that credit rationing is one of thecontributing factors. It is observed that the two main reasons behind credit rationingare asymmetric information and fixation of formal interest rate below the equilibriuminterest rate.In this paper, we are fixing the formal interest rate below the equilibrium level. Thus,in the formal credit market, an excess demand always persist which in turn lead to theemergence of the informal credit sector.The following symbols are used in the representation of the diagram:i * – Formal interest rate at the equilibriumi / – Formal interest rate fixed below the equilibrium rateD L – Demand of LoanS L – Supply of LoanFigure 1Now, we set up the model.The following symbols are used in the representation of the model:Y= Output of the economyN= LabourK * = Capital (constant)P= Overall price levelW = Money wagei = Informal interest rate? = ProfitY= Output of the economyN= Labouri * = Formal interest rate? = Reserve ratioW = Money wagei = Informal interest rateD (i * , Y) = DepositL C ( i, i * ) = Supply of informal credit(1-?) D ( i * , Y) = Supply of formal creditWN ( i, Y ) = Demand for creditY = Output in the home countryC = ConsumptionT = Lump sum taxI (i * ) = InvestmentG = Government expenditureNX = Net exportsP * = Foreign price levelP = Domestic price levele = Fixed exchange rate3.1.PRODUCER BEHAVIOUR AND AS CURVE:The following equations represent our model:Y = F(N,K * ) , F N ; 0 , F NN ; 0 — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — -(3.1.1)? = PY – W(1+i)N? = PF(N,K * ) – W(1+i)N — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — (3.1..2)The working of the model is as follows: We derive the AS curve from the profit maximizingbehaviour. The optimality condition for profit maximization is,– — — — — — — — — — — — — — — — — — — — — — — — — — — (3.1.3)– — — — — — — — — — — — — — — — — — — — — — — — — — — (3.1.4)As, domestic price level increases, real wage falls which leads to a rise in amount of labourand domestic output. Hence, AS is upward sloping 2 .Next, we explore the effect of increase in informal interest rate on the output of the economy.As informal interest rate increases, marginal product of labour (F N ) increases which in turncauses a fall in labour supply (N). Thus, output of the economy falls which leads to a leftwardshift of the AS curve.3.2.CREDIT MARKET EQUILIBRIUM:2 See detailed calculation in the appendixCredit here comes from two sources which are the formal credit market via banks and theinformal credit market.The following equation represents the credit market equilibrium:(1-?)D ( i * , Y) +L C ( i, i * ) =WN ( i, Y ) — — — — — — — — — — — — — — — — — — — — — – (3.2.1)The working of the model: When the output of the economy increases, demand for creditincreases which results in excess demand in credit market. Hence, this leads to an increase inthe informal interest rate.With an increase in formal interest rate, investment in informal sector goes down whereasformal sector deposits increases. But since banks are subject to reserve requirement, they cangenerate loan less than the amount of deposits. So, there is excess demand in the creditmarket and the informal interest rate rises.With an increase in the reserve ratio, the formal credit falls which results in excess demand inthe credit market and thus, informal interest rate rises.Thus, we can conclude that,i = f(Y, i * , ?) — — — — — — — — — – (3.2.2)where,f Y =>0 , f i * = > 0 & f ? => 0 33.3. COMMODITY MARKET EQUILIBRIUM:The following equation represents the commodity market equilibrium:Y= C(Y-T) + I (i * ) + G + NX ( — — — — — — — — — — — — — — — — — — — — — — — — — — — — (3.3.1)The working of the model: From equation (3.3.1), as domestic price level increases, netexport falls which leads to a fall in domestic output. Thus, the AD curve is negatively sloped.3 See detailed calculation in the appendixFigure 24. COMPARATIVE STATICS:A. INCREASE IN FORMAL INTEREST RATE:When the formal interest rate increases, amount of deposit increases, but the bankscannot exhaust the total amount of deposit in generating loans due to reserverequirement. This results in excess demand in formal credit market. Thus, supply ofinformal credit rises which leads to an increase in informal interest rate.Figure 3B. INCREASE IN RESERVE RATIO:As the reserve ratio increases an excess demand in informal credit market arises.Thus, informal interest rate rises. Hence, there is a fall in domestic output, but theeffect on the domestic price level may rise.Figure 45. AN EXTENSION: MODEL UNDER FLEXIBLE EXCHANGE REGIME:Here, we consider the exchange rate to be flexible.The following symbols represent our model:NX = Net exportse = fixed exchange ratee e = Flexible exchange rateP * = Foreign price levelP = Domestic price leveli * = Formal interest ratei ** = World interest rateY = Domestic outputK = CapitalThe following equation represents our model:NX ( + K i * – ( i ** + – 1 ) = 0 — — — — — — — — — — — — — — — — — — — — — — – (5.1)From equation (5.1) we get,Y= C(Y-T) + I (i * ) + G – K i * – ( i ** + – 1 ) — — — — — — — — — — — — — — — — — — — (5.2)The working of the model: From equation (5.2), as formal interest rate goes up,investment falls and capital stock of the economy goes up. Thus, exchange rateappreciates and net export falls which leads to a fall in domestic output but the effecton domestic price is ambiguous.Figure 56. CONCLUSION:In this paper, we have examined the role of informal credit market on the two majormacroeconomic variables, namely, price and output of the economy, in terms of anopen economy AD-AS model. We see that the results are determined by variablessuch as formal interest rate and reserve ratio. These are the various financial sectorreforms that the central bank undertakes to stabilize inflation and output level. In ourtheoretical analysis we have studied the effect of rise in formal interest rate andreserve requirement on the total output level of the economy and the prevailing pricelevel. A rise in any one of the above mentioned variables leads to a fall in output levelunambiguously but the effect on the price level is ambiguous both under alternativeexchange rate regimes.