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 characterized by asymmetric information in the financial market. Low interest rates allow low-productivity firms to enter the pool of borrowers, imposing an information externality that negatively impacts highly productive firms and forces them to reduce their investments. This suggests that, in some cases, although lowering the interest rate can increase total investment and output, it does not necessarily improve welfare. The results align with recent empirical evidence highlighting the adverse effects of low interest rates in southern European countries.