Microfinance is the provision of micro-credit (small loans) to the extremely poor in LDCs. Maybe banks do not exist, asymmetric information means banks do not want to lend money, the poor have no collateral or loan sharks operate in informal markets. The poor do not obtain loans so they cannot begin or develop their businesses.
Microfinance allows subsistence farmers to buy animals, tools and machinery (tractors) to become a commercial farmer and harvest cash crops. This increases the living standards of farmers and helps alleviate poverty because farmers no longer produce for subsistence purposes only but to sell crops on the market. More trade occurs and real GDP increases.
Also, micro-entrepreneurs like farmers may use the loans to employ people to work on their farm, so employment rises. This has a multiplier effect because workers get paid so they increase consumption so AD rises and real GDP rises further.
Additionally, the most vulnerable in LDCs (like women) gain access to credit. Women can then set up their own business for example they could buy sewing machines to set up a knitwear factory. Women could also use the loans to pay for their kids’ education and healthcare.
Furthermore, farmers can use the credit to make themselves less vulnerable to external shocks like extreme weather conditions. A hurricane one year may destroy crops and decrease farmers’ income and consumption. A small loan allows them to still consume when their income drops, then they can repay the loan during the next harvest. Farmers can smooth their consumption overtime.
However, there are some negatives of microfinance: – The poor might be exploited by micro-creditors. Maybe they are charged a high rate of interest or given strict repayment conditions. Given the poor education of many people in LDCs this may be a serious problem. – The most vulnerable people may be shut-off from microfinance. Maybe information does not reach them or they do not have an adequate education to understand how microfinance works. – Maybe other strategies are more important for development such as foreign aid or migration into urban areas. Microfinance should not be overemphasized to the detriment of these other strategies.