Academic journal article Journal of Money, Credit & Banking

Inventory Dynamics and Business Cycles: What Has Changed?

Academic journal article Journal of Money, Credit & Banking

Inventory Dynamics and Business Cycles: What Has Changed?

Article excerpt

FLUCTUATIONS IN U.S. economic activity over the past 20 years have been exceptionally mild compared with previous post-war business cycles. The last two decades saw two of the longest economic expansions and two of the mildest recessions on record, a period of economic performance sometimes dubbed as the "Great Moderation" (Bernanke 2004). Following McConnell and Perez-Quiros (2000), who provided the first rigorous statistical evidence of a decline in the volatility of real GDP that materialized in the mid-1980s, a large number of studies have shown that the increased macroeconomic stability reflects a broad-based reduction in the volatility of many economic variables. (1)

With the volatility decline now well documented, a key unanswered question remains its source. Three hypotheses stand out. One is better policy, namely, a more transparent and credible monetary policy since the "Volcker deflation" of the early 1980s. A second is "good luck," a hypothesis that argues that economic shocks have been both milder and less frequent over the past 20 years. The third is better business practices--in particular, inventory management techniques--spurred by technological advances of the past two decades, which have enabled firms to respond to shocks in a manner that dampens aggregate fluctuations. (2)

In this paper, we utilize disaggregated (by industry and stage of production), monthly data for the U.S. manufacturing sector to examine changes in inventory dynamics and the role such changes may have played in the Great Moderation. We focus on manufacturing for two reasons. First, U.S. manufacturers were early adopters of modern inventory management techniques. Second, McConnell and Perez-Quiros (2000) and Kahn, McConnell, and Perez-Quiros (2001) have identified changes in manufacturing inventory dynamics as having an especially important role in moderating the volatility of output over the past 20 years. By concentrating on the manufacturing sector, we admittedly overlook the role that wholesale and retail inventories may have played in the Great Moderation. (3) However, major changes in the management of retail and wholesale trade inventories appeared to have occurred in the early 1990s, well after the estimated structural break in the volatility of real GDP growth.

In our empirical methodology, we employ a vector autoregression (VAR) model that links industry-level shipments, relative prices, and inventories at different stages of production ("micro-structure") to a model typically used to identify the effects of monetary policy on aggregate economic activity ("macro-structure"). Accounting for both micro- and macro-structures is important because their implications for the Great Moderation differ substantially. For example, in the context of the canonical linear-quadratic (L-Q) model (e.g., Ramey and West 1999), the parameters that determine inventory dynamics can be divided into two sets: (i) the technological parameters controlling the production process, and (ii) the parameters describing the statistical properties of the process for sales, as well as those for the cost and demand shocks. (4) If the reduced volatility of inventory investment resulted from the changes in the first set--the micro structure--this would be consistent with the better practices hypothesis. If instead the reduced volatility was due primarily to changes in the second set, which may be influenced by the changes in the macro environment, this would argue against the better practices hypothesis.

The fact that inventory management and monetary policy both apparently changed substantially around the time of the estimated step-down in the volatility of aggregate economic activity further confounds the search for the source of the Great Moderation. By the mid-1980s, U.S. manufacturers had invested heavily into computerized production and supply-chain management such as integrated physical distribution systems and just-in-time (JIT) techniques. …

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