Low Interest Rates, Capital Misallocation and Welfare

This paper studies how the real interest rate affects the (mis)allocation of capital in a small open economy characterised by asymmetric information in the financial market. Low interest rates accompanied by low entrepreneurial wealth allow unprofitable firms to enter the pool of borrowers. This imposes an information externality on profitable firms, which are forced to decrease their investment levels. In some cases, increases in the interest rate have ambiguous impacts on total investment and output but unambiguously increase welfare. The results can help reconcile recent empirical findings on the adverse effects of low interest rates in southern European countries