Corporate Finance and Interest Rate Policy

Piergallini, Alessandro (2025): 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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Corporate Finance; Firm Financial Structure; Weighted Average Cost of Capital; Distortionary Taxation; Interest Rate Policy; Equilibrium Dynamics; Monetary Policy Shocks.
• Subjects: E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level ; Inflation ; Deflation; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H24 - Personal Income and Other Nonbusiness Taxes and Subsidies; H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H25 - Business Taxes and Subsidies

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