Abstract
Financially constrained firms hold more inventory than do financially unconstrained firms and also show more volatility in inventory holdings. To understand why, we model the interaction of financial constraints, capacity constraints, and the response of production and inventory to cost shocks. We develop several implications as to how financial constraints affect the inventory response to cost shocks of constrained firms relative to unconstrained firms, which cannot be derived from any of a host of other ways in which two groups of firms are differentiated in our model. We find consistent results when we take these implications to the real data.