Recent work on economic growth seeks to explain why some economies may be trapped in a stage of underdevelopment or may go through long periods of stagnation. Part of this literature emphasizes the existence of multiple equilibria arising from some form of externality or coordination failure. Another branch of this literature focuses on fundamentals (preferences, production, or market structure) that determine why poor economies stay poor, while rich economies may be able to sustain permanent growth.
This paper focuses on the role credit market imperfections play in explaining stagnation. In particular, it studies the effects on growth of the inability of individuals to borrow against future income to finance current consumption as well as the possibilities that an economy will become trapped in an equilibrium with low growth.
The model of this paper assumes that the engine of growth is human capital accumulation and that investment in human capital consists of formal education, which transfers income from the present to the future. Because individuals need to consume while receiving education, they must find a source of funds other than labor income to finance their consumption needs. If credit markets functioned without friction, individuals could borrow to finance current consumption and repay the borrowed amount (plus interest) in the future, when their productivity had been enhanced by education. However, if individuals face liquidity constraints, they will have the incentive to reduce the time they devote to education in order to work to finance consumption. In turn, if human capital accumulation is the engine of growth, liquidity constraints may end up reducing the rate of growth. The paper also shows that if the economy is subject to multiple equilibria--one with high growth and the other with low growth--liquidity constraints could increase the likelihood that the economy will end up in low growth equilibrium. Moreover, liquidity constraints could make the high growth equilibrium unattainable. These main ideas are formalized in a simple framework, which, at the cost of realism, clearly highlights the channel through which credit market imperfections, in the form of restrictions to borrowing from future income, may reduce growth.