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Falling interest rates and credit reallocation: lessons from general equilibrium

Author

Listed:
  • Asriyan, Vladimir
  • Laeven, Luc
  • Martin, Alberto
  • Van der Ghote, Alejandro
  • Vanasco, Victoria

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 reallocation is strong enough, a fall in the interest rate reduces aggregate output. A numerical exploration of the model suggests that this reallocation effect i s quantitatively significant an d – in response to persistent changes in th e interest rate – stronger than the traditional balance-sheet channel. We provide evidence of the reallocation effect using US firm-level data. JEL Classification: E22, E23, E32, E44, E52

Suggested Citation

  • Asriyan, Vladimir & Laeven, Luc & Martin, Alberto & Van der Ghote, Alejandro & Vanasco, Victoria, 2025. "Falling interest rates and credit reallocation: lessons from general equilibrium," Working Paper Series 3070, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20253070
    Note: 261593
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    Keywords

    economic activity; general equilibrium; interest rates; reallocation;
    All these keywords.

    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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