Informality, Financial Markets, and Macroeconomic Instability

This research examines the implications of informality for the interaction between real and financial markets, highlighting its role as a structural characteristic that distinguishes developing economies from their developed counterparts, particularly through limited integration with the financial sector. We develop a novel heterogeneous agent model that incorporates two critical dimensions of heterogeneity: the coexistence of formal and informal firms as well as heterogeneous expectation formation processes. Analytical and numerical results reveal a fundamental trade-off. On the one hand, high informality reduces financial volatility due to its limited access to credit and the weak feedback from expectations. On the other hand, it constrains economic activity by limiting the financial sector’s capacity to support investment. An extended version of the model, which endogenises both expectations and informality, further indicates that feedback loops between beliefs and financial access exacerbate instability. Our findings offer new insights into the complex relationship between informality, macroeconomic dynamics, and financial development in structurally heterogeneous economies.