External Debt, Informal Economy and Growth

We develop an endogenous growth model with overlapping generations taking into account important characteristics of the developing countries: high public external debt and large informal sector. We show that an increasing of the public external debt has two opposite effects. On the one hand, it enhances growth through a positive externality affecting the productivity of private firms. On the other hand, it inhibits growth by ousting the external financing of private firms and enlarging the less efficient informal sector. These two effects generate a non-linear effect of the public external debt on growth and an optimal share of the public external indebtedness. We also show that, under a certain condition, the enlargement of the informal sector could be accompanied by higher growth.