ABSTRACT
In many countries, the level of the underground economy is negatively linked to the level of financial development. The causal relationship, though, could go either way. Much of the literature has argued that it is financial development that reduces the level of the underground economy by increasing the opportunity cost of being informal. Recently, some authors argued, instead, that the level of informality hinders financial development by increasing banks' monitoring and screening costs. The chapter presents two simple models showing the two-side relationship between financial development and the size of the underground economy. In both frameworks, borrowers in need of external funding approach a lender (the bank) to run a project. Agents who do not have sufficient resources to offer as collateral, unable to access the credit market, decide to operate in the underground economy. Hence, the financial contract determines whether access to credit and investing is optimal and, in turn, the number of entrepreneurs choosing to go underground. In the first model, the financial system and the level of financial development determine the level of the underground economy; in the second, it is the level of the underground economy to influence bank's lending procedure and, hence, the working of the financial system.
