Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Inventory Investment and the Business Cycle

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Inventory Investment and the Business Cycle

Article excerpt

When reporting on the current state of the economy, the business press gives considerable attention to changes in inventory investment. The reason for the media attention appears to be related to three issues. First, changes in inventory investment apparently account for a substantial fraction of changes in gross domestic product (GDP). Second, current changes in inventory investment are assumed to convey useful information about the nearterm future of the economy. Third, there is a view that the inherent dynamics of inventory investment are destabilizing the economy. In this article I review some of the empirical regularities of inventory investment over the business cycle taking the first issue as a starting point.1 The empirical regularities I choose to study are to some extent determined by particular theories of inventory investment, but any theory of inventory investment should be consistent with these regularities.

The argument that inventory investment is important for the business cycle is often based on the close relationship between changes in inventory investment and GDP during recessions. For example, Blinder (1981) and Blinder and Maccini (1991) argue that, in a typical U.S. recession, declining inventory investment accounts for most of the decline in GDP. In support of this claim, Table I documents the peak-to-trough decline of GDP and inventory investment during postwar U.S. recessions. This same peak-to-trough decline is apparent during the 1980-97 period, as shown in Figure 1.2 Figure 1 also shows that inventory investment is a very noisy time series. During that period, inventory investment not only declines dramatically during recessions, it also declines substantially during expansions. For example, in the expansion years 1986 and 1988, inventory investment declined by almost as much as it did during the 1990 recession. This experience suggests that, while the observation that during recessions declining inventory investment accounts for much of declining GDP is interesting, it might not be very useful when we want to evaluate the role of inventory investment over the complete business cycle.3

Rather than study the behavior of inventory investment for a particular phase of the business cycle, I choose to document the stylized facts of such investment over the entire business cycle using standard methods.4 A stylized fact is an observed empirical regularity between particular variables, which is of interest because economic theory predicts a certain pattern for it. One cannot look for stylized facts without the guidance of economic theory, but economic theory is also developed from the stylized facts uncovered. Since inventory investment DeltaN is the difference between production Y and sales X, that is DeltaN = Y - X, the stylized facts discussed involve the behavior of these three interrelated variables.

1. MODELS OF INVENTORY INVESTMENT

The two leading economic theories of inventory investment are the productionsmoothing model and the (S, s) inventory model. Both theories start with a single firm that solves a dynamic constrained-profit-maximization problem using inventory investment as one of the firm's decision variables.5 The theories differ in how the implications for inventory investment, derived for an individual firm, are applied to the study of aggregate inventory investment.6

A simple production-smoothing model starts with the assumption that a firm's production is subject to increasing marginal cost and that sales are exogenous. If the firm's sales are changing over time but its marginal cost schedule is constant, then the firm minimizes cost by smoothing production, and it reduces (increases) inventories whenever sales exceed (fall short of) production. Thus production is less volatile than sales, and inventory investment and sales tend to be negatively correlated. A firm with increasing marginal cost wants to use inventories to smooth production regardless of whether or not the changes in demand are foreseen. …

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