| Summary: | The aim of this work is to determine the best response of investment to shocks and crisis situations. The problems that arise during crises vary depending on each country's peculiarities. However, there are some things that are common in almost all situations. In very many cases, we find that from the household level where children are pulled out of school and put to work to support family income to the government decision on education funding, one thing is common - investment tends to be cut. In standard optimal growth models consumption and investment generally turn out to be a fixed fraction of output. When a crisis occurs, this fixed fraction of a lower output means a lower level of investment. In an optimal growth framework with Cobb-Douglas production function and logarithmic utility function, I present a model that adds a feature called 'the gap' that describe the domestic situation. Developing countries are often plagued by sociopolitical and economic factors that constrain their productivity and/or capacity utilisation. When weakened in this way, an exogenous shock that causes a loss of capital could have devastating effects. In such a situation depreciation could conceivable exceed its natural rate and it is this difference between the actual rate experienced and the natural rate that I call 'the gap'. I argue that when 'the gap' exists, there are additional benefits to be reaped from investment. The model I present demonstrates that under certain conditions, rather than investing a fixed fraction, the rate of investment should actually increase such that investment is maintained at itspre-crisis level. This is opti~al and desirable because in the long run, the welfare path of economies that follow this strategy is superior. This result is empirically tested using a simple regression model. First, I determine the investment strategy followed by a sample of countries worst hit by the debt crisis of the mid-eighties, then I examine the income and consumption paths. The results show that the majority of the sample countries followed the implied optimal strategy, and these countries followed a superior income and welfare path in the post-crisis years. This result therefore lends support to the model presented, and also raises an important question. Why is it that countries that followed the optimal path only seem to be marginally better off than those that did not? To answer this question, I examine the issue of financing the investment decision. For many countries in crisis, the availability of credit was a crucial factor. Many faced the dilemma of needing funds, yet being unable to attract it because creditors considered them too risky. In an extended version of the basic model, I show that more debt was not optimal for funding the investment choice. Although following the optimal path would result in higher output, as long as funding was through debt, consumption and welfare would only be marginally better because of the future burden of debt service. On the other hand, selffinancing would require severe cuts in consumption that may not be justifiable in terms of long run gains. The solution - aid and financial support for export oriented adjustment programs should be given by international financial organisations to countries that choose to follow the optimal investment strategy. This would preserve and improve the qualityof such organisations' investment, and ensure an even better welfare path for debtor countries in the long run
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