Collateral constraints and the informal economy


We study how occasionally binding endogenous collateral constraints affect entrepreneurs’ decisions to hire workers on an informal basis. By increasing the share of informal but less productive workers, entrepreneurs require less working capital and can borrow more in the financial market. On the other hand, lower average labor productivity decreases output, the demand for capital, and the collateral asset price, tightening the financial constraint. Nonlinear trade-offs arise when the optimal quantity of borrowing approaches the net value of collateral.

Working paper