This paper explores the role of financial stabilisation policy interventions during a crisis. When firms are subject to a shock that restricts their debt to a fraction of their future profits, active entrepreneurs can invest less as a result of tighter credit. The aggregate demand for investment is temporarily 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 real 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.

Are financial stability and allocative efficiency compatible policy objectives? I answer this question in a model where producers exhibit heterogeneous productivity. A borrowing constraint dependent on the price of productive capital has the dual role of generating an externality justifying macroprudential intervention, as well as introducing misallocation. Compared to a constrained efficient allocation, the laissez-faire economy features inefficient wedges in both debt and capital markets. The optimal policy under commitment is in general not time consistent, due to both the forward looking nature of the price of capital as well as the non-linear stochastic discount factor used to price the asset. This prompts the regulator to make promises regarding the future so as to influence current prices, which are no longer optimal ex-post. The policy maker's incentive to deviate from past promises can however be low, if the promised direction of intervention remains the same ex post. Capital requirements can be adopted as policy instruments to implement the constrained efficient allocation in the decentralised economy. However, successful implementation relies on credible commitment to future policies.

Many households prefer homeownership to renting but cannot afford to buy without borrowing, so mortgages can improve allocative efficiency in housing markets. However, highly indebted households may impose aggregate demand externalities when there are nominal rigidities and monetary policy is constrained. Optimal macroprudential limits on mortgage borrowing would trade off housing market distortions against reductions in aggregate demand externalities. In a model calibrated to match features of UK data, we find that debt limits affect interest rates, house prices and rents. Depending on the size and incidence of these general equilibrium effects, macroprudential policy can have different distributional consequences.