Understanding the Credit Multiplier: The Working Capital Channel

We provide novel evidence on how frictions in the financing of working capital amplify and propagate the effect of economic shocks over time. We propose a test for this idea in a situation where firms must pay for inputs in advance of production, and face credit constraints and seasonal variation in profitability. Persistent input price shocks lead to stronger immediate and longer-term drops on firms’ sales when firms are hit in the period in which they are most profitable (their “main quarter”). These patterns are unlikely to be present in the absence of constraints on firms’ ability to finance their inputs. Our analysis implements this test with oil price shocks and suggests that the financing of working capital can be an important channel for understanding how the credit multiplier affects economic activity.