An overlapping-generations model where agents choose whether to become educated when young is presented.
Education enhances productivity, but needs to be financed by borrowing.
Because of the possibility of default, lenders may ration credit. We characterize the steady-state equilibrium with and without credit constraints and show that credit rationing tends to be associated with lower education and a lower real interest rate. We then examine the role of public policy in remedying the inefficiency which occurs in the presence of credit rationing and derive results on optimal public education spending and on allocative and distributional issues.