Corporate finance and interest rate policy

Abstract

I develop flexible- and sticky-price general equilibrium models that embody endogenous corporate financing decisions affecting firm value due to distortionary taxes. Nominal interest-rate variations impact the costs of debt and equity capital asymmetrically and thereby induce firms to modify the financial structure, altering the gap between the optimization-based weighted average cost of capital and the real interest rate. Under these circumstances, I characterize conditions under which rules-based monetary policies that set the nominal interest rate as an increasing function of the inflation rate induce aggregate stability in the form of a unique stable equilibrium. In contrast to what is commonly argued, I demonstrate that both passive interest rate policies, which underreact to inflation, and mildly active interest rate policies, which overreact to inflation but below a threshold reflecting both tax and capital structures, ensure determinacy of equilibrium. Conversely, excessively aggressive inflation-fighting monetary actions are destabilizing in the presence of price stickiness by generating either multiple equilibria or the nonexistence of stable equilibria. Under the stabilizing monetary regimes, I prove that macroeconomic dynamics following either interest rate normalization or temporary monetary tightening critically depend upon the tax code and the steady-state debt-equity ratio.