When demand is low, firms produce less and have lower costs, relaxing the liquidity constraint and enabling them to allocate more resources to investment.

The model also describes the conditions under which firms would move between being constrained and unconstrained. Whether a firm is constrained depends on both its assets and on demand shocks. Financial constraints bind when firms wish to increase output but cannot finance a larger input bill. Firms may be unconstrained at moderate demand levels but become constrained when a higher than average demand shock occurs. As a result, output response to positive shocks is limited. Output response is not limited in response to negative shocks.

The key theoretical predictions of the working capital model are important as they imply that financial constraints limit output of constrained firms just when good production opportunities arise and cause constrained firms to disinvest just when investment should increase.

The second goal of this paper is to examine how financial constraints affect firm output, efficiency and growth over time when working capital is taken into account. I solve the model numerically and subject the model to simulated stochastic shocks over time to illustrate the extent to which financial constraints cause scale and production inefficiencies. Holding initial conditions and parameters constant across the working capital model and the standard investment model, simulations show that constrained firms on average produce 38 percent of optimal output versus the 60 percent predicted by a standard model.<sup>9</sup> Labor to capital ratios are higher than optimal under constraints and the costs of generating a dollar of revenue are higher for constrained firms than for unconstrained firms. These two factors create a loss in producer surplus; numerical results show that the constrained firm achieves on average only 8 percent of possible optimal profits. As firms must rely on internal finance to grow, the reduced profits substantially slow the growth of the firm over time. The time to reach maturity (in terms of being able to produce optimally) is estimated to be around 3 times longer than that predicted by standard investment models under the same financial constraints<sup>10</sup> .

One of the empirical challenges in the literature has been to identify financially constrained firms. Many studies unsatisfactorily use endogenous firm characteristics such as size, outward orientation, or dividend payment as proxies to categorize affected firms (see Hubbard (1998)for review,Fazzari and Petersen (1993); Ganesh-Kumar et al. (2001)). My results suggest that firms’ dynamic behavior can reveal whether they are credit constrained. The results also speak to the ongoing debate in the literature about whether investment cashflow sensitivity indicates financially constrained firms (Kaplan and Zingales (1997, 2000); Fazzari et al. (1988, 2000); Fazzari and Petersen (1993)).

Third, I take the model’s predictions to the data by testing when constraints are likely to bind, and how investment and output of Bangladeshi manufacturing firms respond to demand shocks under financial constraints. The Bangladesh Survey Panel contains unique survey questions that enable me to estimate demand shocks at the firm level. I find strong empirical support for the model’s predictions. Constraints bind when firms experience positive price shocks. This is consistent with the working capital model and in contradiction with the competing thesis that firms become more constrained during downturns.<sup>11</sup> There is evidence that investment of financially constrained firms

> 9The exact magnitude of the difference between models depends on parameter choice.

> 10Recall that a period references the time from production to receipt of revenue, i.e. turnover time. This would differ from industry to industry and may range from 30 days to a quarter or longer. For example, in construction the appropriate time frame of a period would be close to a year. For food manufacturing, a period may reference a month or a couple of weeks. Regardless of the time frame, numerical simulation shows, under standard parameterization, the working capital model predicts a longer time to maturity and slower long run growth than the standard investment model.

> 11Accelerator model, such as Bernanke and Gertler (1989); Bernanke et al. (1996), borrowing is dependent on

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