accurately measured by last period’s revenue.

My empirical strategy assumes that price shocks measure demand shocks. It is possible that instead, price shocks reflect supply shocks, either changes in technology or in factor prices. If price shocks represent technology shocks, the model’s predictions and the interpretation of the results are unchanged. If price shock reflect changes in factor prices, particularly a change in the price of capital, investment would appear to behave countercyclically. However, there is no theoretical basis to suggest that the direction of the response to factor price changes will differ between constrained and unconstrained firms, unless the shocks are different between the two groups. From summary statistics of price changes in Table 9, we see that there are no significant differences in the changes of output price, wages nor raw material prices between constrained and unconstrained firms. Furthermore, these are controlled for in the regression. In summary, even though it is possible that prices may reflect supply shocks, supply shocks cannot explain the significant difference in investment response between constrained and unconstrained

# **4.4 Output Response to Shocks**

Section 4.2 has shown that constraints are more likely to bind when positive production opportunities arise. This implies that financial constraints limit the firm’s output response to positive shocks but do not affect the firm’s response to negative shocks. The empirical specification to test the output response of financially constrained firms is as follows: The change in log output is percentage growth and is measured as the difference from the firm specific mean. I categorize firms into; _Always Constrained_ and _Sometimes Constrained_ using internal finance and access to finance as the financial indicators.<sup>40</sup> All other explanatory variables are the same as those in the investment specification. The specification was estimated using OLS with robust standard errors clustering on firms. Positive shocks are defined as shocks above firm mean and negative shock defined as below mean.

The empirical test is to see whether sometimes constrained firms respond differently to positive shocks than unconstrained firms. Unconstrained firms increase output in response to positive shocks, so _α_ 1 is expected to be positive. _Sometimes Constrained_ firms are limited in their ability to expand, so _α_ 3 is expected to be negative. Unconstrained and _Sometimes Constrained_ firms are predicted to respond to negative shocks in the same way, so _α_ 4 is not expected to be significant. According to the model, _Always Constrained_ firms may have a different response to negative shocks as these firms are producing at a much steeper part of the production function.

Results are shown in Table 13. When the financial constraint dummy is defined based on access, virtually all of the estimated coefficients are insignificant. When the internal finance measure is used, the results are broadly consistent with the working capital model. First, the response to positive

> as emphasized in the literature.

> 40Recall that age and size variables do not indicate the firms transitioning into being financial constrained. _Always Constrained_ is defined as a dummy equal to one when the firm is constrained for all periods and is time invariant. Likewise, _Sometimes Constrained_ is defined as a dummy equal to one when firms are constrained at least once but less than for all periods.

18