This paper addresses the growth, welfare, and distributional effects of credit markets. For this purpose, a general equilibrium model with human capital as the engine of growth is developed. Human capital is accumulated through formal education and individuals differ in their educational abilities. Depending on their ability, individuals choose, in early life, the optimal time allocation between work and education.
The model shows that the optimal decision on the amount of education to acquire depends critically on the existence of credit markets. In particular, it shows that the existence of credit markets induces specialization. Credit markets, by allowing individuals to smooth consumption through borrowing and lending, permit them also to specialize according to their comparative advantage (either education or work) to maximize human wealth. In contrast, in the absence of credit markets, individuals’ decisions on specialization would be limited, since they would have to spend their youth both working and acquiring human capital.
We show that specialization, allowed by the existence of credit markets, unambiguously increases the rate of growth of the economy. The introduction of credit markets allows the more-able to specialize in education and the less-able in working, which enhances the economy’s average efficiency of education. In response to this increase in efficiency, the total amount of time devoted to education in the economy may also increase. It may also be possible that the total time devoted to education declines, but this decline would not offset the increase in the average efficiency of education. Hence, in both cases, human capital accumulation and, consequently, growth increase. In addition, credit markets allow a more beneficial intertemporal allocation of consumption. The positive effects of credit markets on growth and on the intertemporal allocation of consumption lead to an increase in welfare for all current and future generations.
The paper also shows that in economies with a high (low) average level of educational abilities, the opening of credit markets will induce a more disparate (equal) income distribution. In economies with a high level of educational ability, most of the population will spend a large amount of time in education, which will enlarge earning differentials. In contrast, economies with a low level of educational ability, where few people acquire education, the majority will have the same level of earnings since they do not receive education and hence ability, which is the only source of differentiation, will not result in increased income differentials.