DP16720 Falling Interest Rates and Credit Misallocation: Lessons from General Equilibrium

Author(s): Vladimir Asriyan, Luc Laeven, Alberto Martín, Alejandro N Van der Ghote, Victoria Vanasco
Publication Date: November 2021
Keyword(s): asset prices, balance sheet channel, credit, Financial Frictions, Firm Heterogeneity, Low interest rates, Misallocation, monetary policy
JEL(s): E22, E32, E44, E52
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16720

What is the effect of declining interest rates on the efficiency of resource allocation and overall economic activity? We study this question in a setting in which entrepreneurs with different productivities invest in capital, subject to financial frictions. We show that a fall in the interest rate has an ambiguous effect on aggregate output. 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, this higher demand for capital raises its price and crowds out investment by more productive entrepreneurs. When this crowding-out effect is strong enough, a fall in the interest rate becomes contractionary. Moreover, in a dynamic setup, such reallocation effects among entrepreneurs interact with the classic balance-sheet channel, giving rise to a boom-bust impulse response of output to a fall in the interest rate. We show that these reallocation effects are quantitatively important in a calibrated version of the model, and we provide evidence in support of our mechanism using US data.