situation could interfere with technological progress because “risky” entrepreneurs might lack access to the credit they need for innovation. II. Interest Rate as an Incentive Mechanism Borrowing firms are interested primarily in their returns, but banks are investment’s interested in the avoidance of bankruptcy. Noting these differential incentives, banks may firm’s use the interest rate in order to influence behavior. borrowers’ Theorem 7: If, at a given nominal interest rate r, a risk-neutral firm is indifferent between two projects, an increase in the interest rate results in the firm preferring the project with the highest probability of bankruptcy. Essentially, all else equal, as interest rates rise, firms prefer riskier projects. This is evident from the derivative of the expected returns function: borrower’s (14) Since (1-Fi((1+)B-C))>0 because F is a distribution function, d/d <0. Since expected returns fall as interest rates rise, a profit-maximizing firm will increase the riskiness of its chosen project in the face of higher interest rates (see Theorem 2). Combining Theorem 7 with Theorem 3, as the interest rate rises, firms choose riskier projects, and the expected return decreases. bank’s Consider Figure 6:
situation could interfere with technological progress because “risky” entrepreneurs might lack access to the credit they need for innovation. II. Interest Rate as an Incentive Mechanism Borrowing firms are interested primarily in their investment’s returns, but banks are interested in the firm’s avoidance of bankruptcy. Noting these differential incentives, banks may use the interest rate in order to influence borrowers’ behavior. Theorem 7: If, at a given nominal interest rate r, a risk-neutral firm is indifferent between two projects, an increase in the interest rate results in the firm preferring the project with the highest probability of bankruptcy. Essentially, all else equal, as interest rates rise, firms prefer riskier projects. This is evident from the derivative of the borrower’s expected returns function: (14) Since (1-Fi((1+)B-C))>0 because F is a distribution function, d/d <0. Since expected returns fall as interest rates rise, a profit-maximizing firm will increase the riskiness of its chosen project in the face of higher interest rates (see Theorem 2). Combining Theorem 7 with Theorem 3, as the interest rate rises, firms choose riskier projects, and the bank’s expected return decreases. Consider Figure 6: