Does a looser financial regulation during recessions stifle the forces of creative destruction or does it help to avoid job losses and a weak aggregate demand? This paper analyses the effects of a limit on firms' borrowing restricting debt to a fraction of their profits. Constrained firms can invest less, and demand for investment is lower than available savings, so a reduction in the interest rate helps reestablish an equilibrium by inducing unconstrained firms with lower productivity to start production. The constrained equilibrium features too many low-productivity firms: zombies. They generate a negative spillover on the borrowing capacity of more productive firms, as they contribute to reducing the value of profits for all firms, by inflating labour costs. When the interest rate is at the effective lower bound, the opportunity cost of operation is artificially high, so the economy features less investment. As fewer low productivity firms invest, future aggregate productivity is improved, however aggregate demand is low in the present, and output is demand-determined. While liquidating zombie firms away from the lower bound can improve the efficiency of the allocation, it can be counterproductive at the lower bound, as these firms are not zombies but make use of idle resources, boosting output and welfare.
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