Falling Interest Rates and Credit Misallocation: Lessons from General Equilibrium

Alejandro Van der Ghote, Luc Laeven, Victoria Vanasco, Alberto Martin and Vladimir Asriyan

No 1268, Working Papers from Barcelona School of Economics

Abstract: 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.

Keywords: monetary policy; financial frictions; firm heterogeneity; misallocation; low interest rates; credit asset prices (search for similar items in EconPapers)
JEL-codes: E22 E32 E44 E52 (search for similar items in EconPapers)
Date: 2021-07
New Economics Papers: this item is included in nep-cba and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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