borrowing constraints as functions of other variables, or incorporated into a general equilibrium framework. Although the interest of this paper has been on the firm’s dynamic response to demand shocks, the model may yield interesting insights into other areas such as firm behavior in response to interest rate changes<sup>42</sup> , output volatility over the business cycle<sup>43</sup> , sector development with limited access to external credit<sup>44</sup> and the of trade liberalization under constraints<sup>45</sup> .

In this paper, I empirically test three predictions in particular: constraints bind when prices increase, the countercyclical behavior of capital under binding constraints and the asymmetric output response. These predictions differ from the commonly used Jorgenson model of investment with financial constraints and allow comparisons of the working capital model to the standard model. I find that the working capital model’s predictions are consistent with empirical evidence. These findings suggest that studying the dynamic behavior of firms may be a promising strategy for identifying which firms are credit constrained. Furthermore, these two predictions provide a means of identification of constrained firms that does not rely on the occurrence of a natural experiment or endogenous firm characteristics.

# **References**

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- **, , and Simon Gilchrist** , “The Financial Accelerator and the Flight to Quality,” _The Review of Economics and Statistics_ , feb 1996, _78_ (1), 1–15.

- **Bigsten, Arne, Paul Collier, Stefan Dercon, Marcel Fafchamps, Bernard Gauthier, and Jan Willem Gunni** , “Adjustment Costs and Irreversibility as Determinants of Investment: Evidence from African Manufacturing,” _Contributions to Economic Analysis & Policy_ , 2005, _4_ (1), 1228–1228. available at http://ideas.repec.org/a/bep/eapcon/v4y2005i1p1228-1228.html.

- **Bloom, Nick, John Van Reenen, and Stephen Bond** , “Uncertainty and Investment Dynamics,” Working Paper 12383, National Bureau of Economic Research July 2006.

- **Bond, S. and J. Van Reenen** , “Microeconometric Models of Investment and Employment.,” _forthcoming in J. Heckman and E. Leamer (eds) Handbook of Econometrics, Volume 6_ , 2007.

- **Bond, Stephen and Costas Meghir** , “Dynamic Investment Models and the Firm’s Financial Policy,” _The Review of Economic Studies_ , apr 1994, _61_ (2), 197–222.

- **, Julie Ann Elston, Jacques Mairesse, and Benoit Mulkay** , “Financial Factors and Investment in Belgium, France, Germany, and the United Kingdom: A Comparison Using Company Panel Data,” _Review of Economics and Statistics_ , 2003, _85_ (1), 153–165.

> to look at precautionary savings by the firm.

> 42The model allows the firm to choose between internal finance (vulnerable to real shocks) and external credit (vulnerable to interest rate shocks).

> 43The working capital model exhibits propagation of temporary shocks past the period when the shock occurred, even though the shock is i.i.d.

> 44Differences in factor intensities between industries could generate different rates of growth but also different sector responses to shocks under financial constraints.

> 45Financial constraints restrict expansion to markets, therefore under trade liberalization where market opportunities %%% I develop this in another paper.

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