al (1994) find supporting evidence by analysing how firms adjust their investment in response to “cash windfalls”. They argue that such windfalls are unrelated to future profitability.

Other research, using different approaches, also emphasise the importance of financial imperfections. Lamont (1997) analyses internal capital markets of oil companies and finds that, in response to a sudden drop in oil prices, these companies significantly reduce their non-oil investment compared with other companies. Since this approach controls for the profitability of investments, it provides evidence of the importance of cash flows for investment. A number of other studies, including those on the determinants of inventories and employment, also point to the critical role of imperfections.<sup>12</sup> Another strand of the literature uses information extracted from CEO’s public statements and surveys to assess directly whether firms are credit-constrained (Graham and Harvey (2001)).

Imperfections are acutely important for small firms, particularly during times of financial stress. Because such firms have more limited access to financial markets (because they have less collateral or are less transparent to outside investors), imperfections are often more relevant to them (Petersen and Rajan (1995)). Fazzari et al (1988)) find that investment is indeed significantly more sensitive to current cash flows for new and small firms. In a related study, Gertler and Hubbard (1988) report an inverse relationship between firm size and sales variability that stems from imperfections. They also find that the effects of financial market frictions on investment are asymmetric, with larger impacts during downturns than during booms. Fort et al (2013) show that young (typically small) businesses are more sensitive to the cycle than older/larger businesses. Campello et al (2010) and other papers document the adverse implications of financial constraints during a financial crisis (see Peek and Rosengren (2016) for a comparison of supply side effects between the GFC and previous crises).

Other studies also examine the importance of internal cash flow and asset price movements for the investment undertaken by different classes of firms. Gilchrist and Himmelberg (1999), for example, document that internal cash flow is critical for investment, especially for firms that are small, have limited access to credit markets and have relatively weaker balance sheets. They find that investment is responsive to both fundamental and financial factors, as predicted by the theory relating to financial frictions. Their estimates show that financial factors increase the overall response of investment to an expansionary shock by about 25% over the first few years following the initial shock. Chaney et al (2012) and Gan (2007) find a significant impact of asset (real estate) prices on corporate investment in the United States and Japan (see also Lin et al (2011) for the role of ownership structures for financing constraints).

Studies also report that small firms are more likely to be credit-constrained during periods of contractionary monetary policy. Gertler and Gilchrist (1994) examine the behaviour of small and large manufacturing firms in the United States during five periods of contractionary monetary policy and one period of credit crunch. They document that small and large firms behave differently during these periods, with the former group reducing its debt and the latter one increasing it. Small firms experience larger declines in their inventories and sales than large firms (Figure 1). They conclude that because large firms have easier access to credit, the impact of adverse credit market shocks is less pronounced for them than it is for smaller firms. Sharpe (1994) provides similar supporting evidence and concludes that the cyclicality of a firm’s labour force is inversely related to its size.

> 12 See for additional work, Cantor (1990), Blinder and Maccini (1991), Oliner and Rudebusch (1993), Carpenter et al (1994) and Guiso et al (2013).

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