as the constraint indicators, because age and size never switch from unconstrained to constrained. Controls for firm characteristics are: sectors, log age, change in log wage and change in interest rates averaged over sector and time. Change from firm specific mean of log output price is used as the change in shock. The expected sign for the coefficient _λ_ 1 for the response to price changes is positive.

Empirical results are shown in Table 11. Across all specifications, the estimates for _λ_ 1 are positive and significant at the 5% level. As predicted by the working capital model, and contrary to conventional wisdom, positive price shocks are associated with movements into a constrained state. In other words, constraints bind precisely when good opportunities arise.

# **4.3 Investment Response to Shocks**

The model’s prediction is that when financial constraints are binding, investment reacts countercyclically to demand shocks. Motivated by the solution to the firm’s dynamic problem that states that the firm’s choice of inputs depends only on the state variables, the stochastic factor, and the exogenous parameters, I estimate the following specification: The dependent variable is the change in log capital stock. Initial capital stock, reported present value of machinery, equipment, land, buildings and leasehold improvement, comes from the 2002 Investment Climate Assessment (ICA) survey.<sup>37</sup> Capital investment in each period is the net spending<sup>38</sup> on additional machinery, equipment, vehicles, land and buildings. The lagged log value of capital and revenue, _R_ , are used for the state variables, capital stock and cash in hand respectively. Revenue is interacted with the constraint variable, _cnstr_ , as cash should only matter when the firm is constrained. The stochastic variable is the change in log output price, _shock_ . I also control for industrial sector, lagged firm size, change in log wages, sector- and time-specific interest rates, and a linear time trend.

The model predicts that investment is countercyclical when the firm is in the always financially constrained phase. I use two different methods to measure binding constraints: First, I define the firm as consecutively constrained if the firm is financially constrained in periods _t_ and _t −_ 1, and second, I define the firm as consistently constrained if it is constrained for all periods the indicator is observed. The consecutively constrained indicator is firm- and time- variant whereas the consistently constrained indicator varies across firms only.

The empirical test is to see if the investment of constrained firms responds negatively to a price shock while the investment of unconstrained firms responds positively. That is, the coefficient on the interaction between the financial constraint indicator and the price shock, _α_ 3, should be negative

> 37The 2003-2005 panel is linked to the 2002 Investment Climate Assessment (ICA) survey. The ICA surveyed 1000 firms and has a more comprehensive and detailed survey questionnaire. The panel survey follows up firms interviewed in the 2002 ICA and firms are matched according to identification numbers. Comparing establishment years reported 2002 ICA and 2003 wave of the panel suggests that there may be matching errors. Approximately 40% of the firms have discrepancies in the establishment year. There are 52 firms with a discrepancy of over 5 years. These firms were left out of the sample in empirical analysis.

> 38Net investment is the additional spending minus sales of additional machinery, equipment, vehicles, land and buildings.

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