Using a unique dataset covering the universe of Portuguese firms, their credit situation, and bank relationship we show that firms across the entire size distribution exhibit a positive elasticity of loans and capital to credit supply shocks. This finding is counterfactual to basic theory that posits large firms as unconstrained and not reacting to credit supply shocks. Incorporating a richer, empirically supported, productivity process into a standard heterogeneous firms model generates large constrained firms and consequently a joint distribution of size and credit elasticities in line with the data. The elevated capital share and sensitivity to financial shocks of the largest decile of constrained firms explains about onethird of the response of output to a financial shock.

A simple model predicts that firms with lumpy investment profiles face elevated external finance premia, leading to a reduced propensity to adjust. This creates lumpy investment spirals - firms failing to adjust also face higher premia in the future, decreasing their propensity to invest tomorrow. Using Compustat data we show that these predictions are consistent with observed investment lumpiness and risk premium patterns. Finally, we analyse how the presence of lumpy investment spirals affects capital misallocation and aggregate shock sensitivity in a heterogeneous firms model with financial frictions.

A sticky price theory of the transmission mechanism of monetary policy shocks based on state-dependent pricing yields two testable implications, that do not hold in time-dependent models. First, large monetary policy shocks should yield proportionally larger initial responses of the price level. Second, in a high trend inflation regime, the response of the price level to monetary policy shocks should be larger and real effects smaller. Our analysis provides evidence supporting these non-linear effects in the response of the price level in aggregate US data, indicating state-dependent pricing as an important feature of the transmission mechanism of monetary policy.