The Role of Inventories in the Business Cycle

By Khan, Aubhik | Business Review (Federal Reserve Bank of Philadelphia), Fall 2003 | Go to article overview

The Role of Inventories in the Business Cycle


Khan, Aubhik, Business Review (Federal Reserve Bank of Philadelphia)


Changes in the stock of firms' inventories are an important component of the business cycle. Alan Blinder, a former Governor of the Federal Reserve System, famously remarked that "the business cycle, to a surprisingly large degree, is an inventory cycle." Consistent with this perspective, much of the discussion about the timing of a recovery following economic recessions focuses on firms' stocks of inventories. Pundits suggest that production and employment cannot recover until firms' inventories fall, relative to their sales.

This article surveys the facts about inventory investment over the business cycle, then discusses two leading theories of inventory investment that may explain these observations. Theory that passes the test of observation may allow us, with some confidence, to predict future movements in the data. Theories that have sought to explain macroeconomic changes in inventory investment have generally focused on firms' attempts to (1) reduce the costs of adjusting their production level or (2) reduce the costs of placing orders for intermediate goods. While much of the research on inventories in the past 50 years has emphasized the cost of adjusting production, this approach has had well-known difficulties when confronted with the data. Recent work that has focused on reducing the fixed costs of ordering goods may provide a framework that is more consistent with the facts. At the same time, this recent work may produce new insights about the interaction between inventories and the macroeconomy. These two theories predict different behavior for aggregate production, sales, and inventory investment.

INVENTORIES SEEM TO BE IMPORTANT IN THE BUSINESS CYCLE

Figure 1 shows the business-cycle component of real gross domestic product (GDP) in the United States over most of the postwar period. We can think of movements in GDP as the sum of two components: the trend and the business cycle. The trend represents the average growth rate of the economy across surrounding years. The business cycle reflects short-term deviations from this trend: the expansions and contractions that make up the business cycle. (1,2) For comparison, recessions, as dated by the National Bureau of Economic Research, are shaded in the figure.

The figure also includes changes in the stock of private nonfarm inventories (private refers to non-government). The difference between GDP, the sum of all goods and services produced in the economy over a given period, and final sales, the sum of all goods and services sold, is known as net inventory investment. Net inventory investment is a measure of goods that have been made but not sold to consumers nor used by a firm as an intermediate input into production.

A car made by Honda in Ohio, completed but retained unused in the factory, adds to Honda's stock of inventories. Steel bought by the same manufacturer but left unused is a raw material that also adds to Honda's stock of inventories. Nonfarm private inventories are essentially stocks of these final goods, intermediate inputs, materials, or supplies held by businesses. Changes in this component of total inventory investment account for most of the change in total inventories over the business cycle.

Cyclicality and Volatility. In organizing their thinking about the role of an economic variable such as inventory investment over the business cycle, economists focus on the cyclicality and volatility of the variable. A variable's cyclicality--formally, its correlation with real GDP--is a measure of how the variable changes over the business cycle. For example, net exports--that is, exports minus imports--are countercyclical: they fall as GDP rises during an expansion, and they rise as GDP declines in a recession.

In contrast, consumption and investment are pro-cyclical: they rise during expansions and fall, alongside GDP, in recessions. A significant correlation, whether positive or negative, between any economic variable and GDP suggests that the variable is cyclical in that it varies in a systematic way with GDP over the business cycle. …

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