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Falling interest rates and credit reallocation: Lessons from general equilibrium

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

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

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: Low interest rates; financial frictions; firm heterogeneity; misallocation; credit; asset prices; monetary policy (search for similar items in EconPapers)
JEL-codes: E22 E32 E44 E52 (search for similar items in EconPapers)
Date: 2021-05, Revised 2022-06
New Economics Papers: this item is included in nep-ent and nep-fdg
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