Interest Rates and Selection Along the Business Cycle

Abstract

This paper studies the effect of interest rates on market selection. Consistent with the evidence, I demonstrate that busts exhibit adverse selection, whereas booms ac- companied by ultra-low rates exhibit advantageous selection. Interestingly, booms accompanied by intermediate interest rates simultaneously exhibit adverse and ad- vantageous selection. Changes in interest rates affect selection and, hence, the quan- tity and quality of loans. When interest rates are endogenous, multiple equilibria arise, although higher interest rate equilibria imply more and better loans. Adverse selection attenuates the stimulatory effects of monetary policy, and zero interest rates can lead banks to hoard cash. Several extensions and robustness checks are applied.