Falling Interest Rates and Credit Misallocation: Lessons from General Equilibrium

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 the 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 can 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 provide evidence in support of our mechanism using data from the US and Spain.