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Understanding the Inventory Cycle

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  • Wen, Yi

    (Cornell U)

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Abstract

Why is there inventory investment when its expected rate of return is strictly dominated by that of fixed-capital investment? Why is inventory investment procyclical at business-cycle frequencies but countercyclical at the very high frequencies (e.g., 2-3 quarters per cycle)? Why does the variance of production exceed the variance of sales at the business-cycle frequencies but not so at the high frequencies? Why is inventory investment so volatile relative to GDP at the high frequencies but not so at the business cycle frequencies? Explaining these seemingly paradoxical features of inventory behavior is of great importance because for many years economists have speculated that understanding inventory fluctuations may provide the key to understanding the business cycle. This paper provides a general equilibrium analysis on inventory cycles and their relations to the business cycle. I show that in an environment where production and fixed-capital investment cannot adjust instantaneously to respond to consumption demand shocks, firms opt to hold inventories in the short run so as to avoid stockout and to smooth production against demand uncertainty. These incentives for holding inventories in the short run have different effects on inventory cycles across different cyclical frequencies. At the high frequencies inventory fluctuations are dominated by the production-smoothing motive and at the business-cycle frequencies inventory fluctuations are dominated by the stockout-avoidance motive. Consequently, inventory investment appears to be countercyclical and volatile at the high frequencies but procyclical and relatively smooth at the business-cycle frequencies, production appears to be less volatile than sales at the high frequencies but more volatile than sales at the business-cycle frequencies. I also show that the inventory cycle and the business cycle are intimately related by sharing a common source of uncertainty--consumption demand, which leads to the phenomena that consumption Granger causes output and fixed investment, that consumption comoves with output and fixed investment, and that consumption appears to be smooth relative to output and fixed investment.

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Paper provided by Cornell University, Center for Analytic Economics in its series Working Papers with number 02-04.

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Date of creation: Aug 2002
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Handle: RePEc:ecl:corcae:02-04

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  1. Mark Bils & James A. Kahn, 1999. "What inventory behavior tells us about business cycles," Staff Reports 92, Federal Reserve Bank of New York.
  2. Brad R Humphreys & Louis J Maccini & Scott Schuh, 1997. "Input and Output Inventories," Economics Working Paper Archive 391, The Johns Hopkins University,Department of Economics.
  3. Caballero, R.J., 1994. "Explaining Investment Dynamics in U.S. Manufacturing: Generalized (S,s) Approach," Working papers 94-32, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Aubhik Khan & Julia K. Thomas, 2004. "Inventories and the business cycle: an equilibrium analysis of (S,s) policies," Working Papers 04-11, Federal Reserve Bank of Philadelphia.
  5. Kahn, James A, 1992. "Why Is Production More Volatile Than Sales? Theory and Evidence on the Stockout-Avoidance Motive for Inventory-Holding," The Quarterly Journal of Economics, MIT Press, vol. 107(2), pages 481-510, May.
  6. Martin Feldstein & Alan Auerbach, 1976. "Inventory Behavior in Durable-Goods Manufacturing: The Target-Adjustment Model," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 7(2), pages 351-408.
  7. Martin S. Eichenbaum, 1990. "Some Empirical Evidence on the Production Level and Production Cost Smoothing Models of Inventory Investment," NBER Working Papers 2523, National Bureau of Economic Research, Inc.
  8. Blanchard, Olivier J, 1983. "The Production and Inventory Behavior of the American Automobile Industry," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 365-400, June.
  9. Kenneth D. West, 1985. "A Variance Bounds Test of the Linear Quardractic Inventory Model," NBER Working Papers 1581, National Bureau of Economic Research, Inc.
  10. Ramey, Valerie A, 1991. "Nonconvex Costs and the Behavior of Inventories," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 306-34, April.
  11. Alan S. Blinder, 1984. "Can The Production Smoothing Model of Inventory Behavior be Saved?," NBER Working Papers 1257, National Bureau of Economic Research, Inc.
  12. Alan S. Blinder, 1981. "Retail Inventory Behavior and Business Fluctuations," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 12(2), pages 443-520.
  13. Brown, Ward & Haegler, Urs, 2004. "Financing constraints and inventories," European Economic Review, Elsevier, vol. 48(5), pages 1091-1123, October.
  14. Maccini, Louis J & Zabel, Edward, 1996. "Serial Correlation in Demand, Backlogging and Production Volatility," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 37(2), pages 423-52, May.
  15. Wen, Yi, 2002. "Fickle Consumers versus Random Technology: Explaining Domestic and International Comovements," Working Papers 02-01, Cornell University, Center for Analytic Economics.
  16. Yi Wen, 2005. "Durable good inventories and the volatility of production: explaining the less volatile U.S. economy," Working Papers 2005-047, Federal Reserve Bank of St. Louis.
  17. Wen, Yi, 2003. "The Power of Demand: A General Equilibrium Analysis of Multi-Stage-Fabrication Economy with Inventories," Working Papers 03-13r, Cornell University, Center for Analytic Economics.
  18. Christiano, Lawrence J., 1988. "Why does inventory investment fluctuate so much?," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 247-280.
  19. Abel, Andrew B, 1985. "Inventories, Stock-Outs and Production Smoothing," Review of Economic Studies, Wiley Blackwell, vol. 52(2), pages 283-93, April.
  20. Wen, Yi, 2005. "Understanding the inventory cycle," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1533-1555, November.
  21. Kahn, James A, 1987. "Inventories and the Volatility of Production," American Economic Review, American Economic Association, vol. 77(4), pages 667-79, September.
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