Falling Interest Rates and Credit Misallocation: Lessons from General Equilibrium

• Authors: Victoria Vanasco, Alberto Martin and Vladimir Asriyan.
• BSE Working Paper: 110741 | July 21
• Keywords: monetary policy , financial frictions , firm heterogeneity , misallocation , low interest rates , credit asset prices
• JEL codes: E22, E32, E44, E52
• monetary policy
• financial frictions
• firm heterogeneity
• misallocation
• low interest rates
• credit asset prices

We show that in a canonical model with heterogeneous entrepreneurs, financial frictions, and an imperfectly elastic supply of capital, a fall in the interest rate has an ambiguous effect on aggregate economic activity. In partial equilibrium, a lower interest rate raises aggregate investment both by relaxing financial constraints and by prompting relatively less productive entrepreneurs to invest. In general equilibrium, however, this higher demand for capital raises its price and crowds out investment by more productive entrepreneurs. When this general-equilibrium induced reallocation is strong enough, a fall in the interest rate reduces aggregate output. We show that this reallocation effect is of the same order of magnitude as the balance-sheet channel, and that the interaction of both gives rise to boom-bust dynamics in response to a fall in the interest rate. Our novel mechanism contributes to the debate on whether and how low-interest environments may foster the proliferation of socially unproductive activities.