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The present paper develops a model of vertical linkage between the formal and informal credit markets highlighting the presence of corruption in the distribution of formal credit. The existingmoneylender, the bank official and the new moneylenders move sequentially and the existingmoneylender acts as a Stackelberg leader and unilaterally decides on the informal interest rate.The analysis distinguishes between two different ways of designing a credit subsidy policy. If acredit subsidy policy is undertaken through an increase in the supply of institutional credit it islikely to increase the competitiveness in the informal credit market and lower the informal sectorinterest rate under reasonable parametric restrictions. Any change in the formal sector interestrate has no effect. An anticorruption measure, on the contrary, may be counterproductive andraise the interest rate in the informal credit market.

Corruption in a Model of Vertical Linkage Between Formal and Informal Credit Sources and Credit Subsidy Policy