Falling Interest Rates and Credit Reallocation: Lessons from General Equilibrium

Victoria Vanasco, Alberto Martin, Alejandro Van der Gothe, Luc Laeven, Vladimir Asriyan  , - Jul 13, 2023

Working Paper No.   00107-00

We show that in a canonical model with heterogeneous entrepreneurs, financial fric-tions, and an imperfectly elastic supply of capital, a fall in the interest rate has an am-biguous effect on aggregate economic activity. In partial equilibrium, a lower interestrate raises aggregate investment both by relaxing financial constraints and by promptingrelatively less productive entrepreneurs to invest. In general equilibrium, however, thishigher demand for capital raises its price and crowds out investment by more productiveentrepreneurs. When this general-equilibrium induced reallocation is strong enough, afall in the interest rate reduces aggregate output. We show that this reallocation effect isof the same order of magnitude as the balance-sheet channel, and that the interaction ofboth gives rise to boom-bust dynamics in response to a fall in the interest rate. Our novelmechanism contributes to the debate on whether and how low-interest environments mayfoster the proliferation ofsociallyunproductive activities.


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Falling Interest Rates and Credit Reallocation: Lessons from General Equilibrium

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