Informality, financial markets, and macroeconomic instability

Abstract This paper studies how informality reshapes real–financial feedback and the emergence of endogenous macroeconomic instability in developing economies. We develop a parsimonious nonlinear model that combines (i) an underwriting-based liquidity–solvency mechanism in which funding conditions in the financially integrated segment depend on discounted expectations of liquidity, and (ii) a demand-driven real block with bounded output adjustment in a dual economy where informal activity is more cash-flow based and has lower short-run adjustment capacity. In the baseline map, effective formality governs a trade-off: greater financial integration and productive capacity raise average activity, but also strengthen belief-sensitive financing conditions and move the economy closer to instability. Local analysis characterizes Flip (period-doubling) and Neimark–Sacker bifurcation routes. We then endogenize belief composition and effective formal participation via performance-based (logit) updating interpreted as cyclical variation in reliance on formal instruments. Stochastic simulations and Monte Carlo sensitivity analysis show that volatility is driven mainly by the intensity of cyclical reallocation between formal and informal margins.