Date Added: Dec 2010
Financial constraints are widespread in developing countries, where even short term credit is limited. Finance held by firms as working capital is a substantial proportion of sales revenue, yet the role of working capital is largely neglected by existing models of financial constraints. The author presents a dynamic model of the firm that incorporates working capital by introducing a delay between factor payments and the receipt of revenue. In contrast with previous models, the working capital model predicts that firms under binding constraints will substitute between labor and capital in response to demand shocks, causing investment to be countercyclical. For firms near the margin of being constrained, constraints bind when positive production opportunities arise.