Inadequate Formal Credit and the Informal Credit Market in Agriculture : A Theoretical Analysis

A theoretical analysis of interest rate determination in the informal credit market has been presented when the market for informal credit is created by inadequate supply of formal credit. The official of the formal credit agency controls the supply of formal credit and he gets a bribe from the moneylender when he rations the supply of formal credit to the farmer. The moneylender and the official play a cooperative game choosing jointly the amount of formal credit and the informal interest rate. Development policy like a credit subsidy policy reduces the informal interest rate and raises the amount of formal credit disbursed by the official. On the contrary, a price subsidy policy raises the informal interest rate and lowers the amount of formal credit disbursed. The paper is an attempt to justify the desirability of a credit subsidy policy theoretically when it is being questioned in a developing country like India