Debt, Poverty and Resource Management in a Rural Smallholder Economy

Abstract

This paper develops a model to capture the key features of poverty, credit constraints and resource management faced by poor rural households. We assume that, due to the existence of asymmetric information and moral hazard, the household faces an increasing cost of credit as its debt/equity ratio rises. A household exploiting a natural resource may fall into a poverty trap, but only if it is unable to afford the increasing borrowing costs implied by increasing debt to allow it to avoid such a trap, or if it discounts future utility so much that a balanced growth path cannot be financed at any level of long-run borrowing. In contrast, along an optimal balanced growth path, the household’s asset wealth, purchased inputs, resource stock and consumption increase at the same constant rate. However, over the long run there may be carrying capacity limits that prevent the resource from improving further. The household may then direct its savings to accumulating financial assets, and eventually under certain conditions may become a net creditor with resource exploitation becoming a less and less important source of its income.