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There is an ongoing debate about whether credit subsidies improve welfare or not. We build a model of monopolistic competition with liquidity constrained firms to analyze the optimal credit subsidy policy. The contribution of this paper is to determine the role of interest rates on optimal credit subsidies. This paper shows that i) there exists an optimal credit subsidy level which always increases welfare; ii) however, some subsidy levels can decrease welfare compared to no policy case, and iii) the market interest rate plays a crucial role in determining the optimal level for credit subsidy.

Liquidity Constraints, Interest Rates and Optimal Credit Subsidies