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Inventories and Optimal Monetary Policy

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  • Thomas A. Lubik

    ()

  • Wing Leong Teo

    ()

Abstract

We introduce inventories into a standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model to study the effect on the design of optimal monetary policy. The possibility of inventory investment changes the transmission mechanism in the model by decoupling production from final consumption. This allows for a higher degree of consumption smoothing since firms can add excess production to their inventory holdings. We consider both Ramsey optimal monetary policy and a monetary policy that maximizes consumer welfare over a set of simple interest rate feedback rules. We find that in contrast to a model without inventories, Ramsey-optimal monetary policy in a model with inventories deviates from complete inflation stabilization. In the standard model, nominal price rigidity is a deadweight loss on the economy, which an optimizing policymaker attempts to remove. With inventories, a planner can reduce consumption volatility and raise welfare by accumulating inventories and letting prices change as an equilibrating mechanism. We find also find that the application of simple rules comes very close to replicating Ramsey optimal outcomes.

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Bibliographic Info

Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2010-07.

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Length: 33 pages
Date of creation: Feb 2010
Date of revision:
Handle: RePEc:een:camaaa:2010-07

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  1. Mark Bils & James Kahn, 1998. "What inventory behavior tells us about business cycles," Research Paper 9817, Federal Reserve Bank of New York.
  2. Peter N. Ireland, 2004. "Technology Shocks in the New Keynesian Model," The Review of Economics and Statistics, MIT Press, vol. 86(4), pages 923-936, November.
  3. Thomas A. Lubik & Wing Leong Teo, 2010. "Inventories, Inflation Dynamics and the New Keynesian Phillips Curve," CAMA Working Papers 2010-13, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  4. Christiano, Lawrence J., 1988. "Why does inventory investment fluctuate so much?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 21(2-3), pages 247-280.
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  7. Louis J. Maccini & Adrian Pagan, 2006. "Inventories, Fluctuations and Business Cycles. Working paper #4," NCER Working Paper Series, National Centre for Econometric Research 4, National Centre for Econometric Research.
  8. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, Econometric Society, vol. 50(6), pages 1345-70, November.
  9. 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.
  10. Krause, Michael U. & Lubik, Thomas A., 2007. "The (ir)relevance of real wage rigidity in the New Keynesian model with search frictions," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(3), pages 706-727, April.
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  12. Fisher, J.D.M. & Hornstein, A., 1995. "(S,s)Inventory Policies in General Equilibrium," UWO Department of Economics Working Papers, University of Western Ontario, Department of Economics 9514, University of Western Ontario, Department of Economics.
  13. Stephanie Schmitt-Grohe & Martin Uribe, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," NBER Working Papers 10253, National Bureau of Economic Research, Inc.
  14. Aubhik Khan & Julia K. Thomas, 2007. "Inventories and the Business Cycle: An Equilibrium Analysis of ( S, s ) Policies," American Economic Review, American Economic Association, American Economic Association, vol. 97(4), pages 1165-1188, September.
  15. Yongseung Jung & Tack Yun, 2005. "Monetary policy shocks, inventory dynamics, and price-setting behavior," Working Paper Series 2006-02, Federal Reserve Bank of San Francisco.
  16. Chang, Yongsung & Hornstein, Andreas & Sarte, Pierre-Daniel, 2009. "On the employment effects of productivity shocks: The role of inventories, demand elasticity, and sticky prices," Journal of Monetary Economics, Elsevier, Elsevier, vol. 56(3), pages 328-343, April.
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  18. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," Departmental Working Papers, Rutgers University, Department of Economics 200106, Rutgers University, Department of Economics.
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  21. Andrew T. Levin & Alexei Onatski & John Williams & Noah M. Williams, 2006. "Monetary Policy Under Uncertainty in Micro-Founded Macroeconometric Models," NBER Chapters, in: NBER Macroeconomics Annual 2005, Volume 20, pages 229-312 National Bureau of Economic Research, Inc.
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Cited by:
  1. Thomas A Lubik & Wing Teong Teo, . "Inventories, Inflation Dynamics and the New Keynesian Phillips Curve," Discussion Papers 10/02, University of Nottingham, Centre for Finance, Credit and Macroeconomics (CFCM).
  2. Marcel Förster, 2013. "The Great Moderation: Inventories, Shocks or Monetary Policy?," MAGKS Papers on Economics, Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung) 201348, Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung).
  3. Teo, Wing Leong, 2011. "Inventories and optimal monetary policy in a small open economy," Journal of International Money and Finance, Elsevier, Elsevier, vol. 30(8), pages 1719-1748.
  4. repec:mar:magkse:201123 is not listed on IDEAS

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