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Inventories and Optimal Monetary Policy

  • Thomas A. Lubik

    ()

    (Federal Reserve Bank, Richmond)

  • Wing Leong Teo

    ()

    (Department of Economics, National Taiwan University)

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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File URL: http://www.economics.adelaide.edu.au/research/papers/doc/wp2009-33.pdf
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Paper provided by University of Adelaide, School of Economics in its series School of Economics Working Papers with number 2009-33.

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Length: 33 pages
Date of creation: 2009
Date of revision:
Handle: RePEc:adl:wpaper:2009-33
Contact details of provider: Postal: Adelaide SA 5005
Phone: (618) 8303 5540
Web page: http://www.economics.adelaide.edu.au/

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  1. Christiano, Lawrence J., 1988. "Why does inventory investment fluctuate so much?," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 247-280.
  2. Aubhik Khan & Julie K. Thomas, 2003. "Inventories and the business cycle: an equilibrium analysis of (S,s) policies," Staff Report 329, Federal Reserve Bank of Minneapolis.
  3. Jonas D.M. Fisher & Andreas Hornstein, 1996. "(S, s) inventory policies in general equilibrium," Working Paper Series, Macroeconomic Issues WP-96-24, Federal Reserve Bank of Chicago.
  4. Krause, M.U. & Lubik, T.A., 2003. "The (Ir)relevance of Real Wage Rigidity in the New Keynesian Model with Search Frictions," Discussion Paper 2003-113, Tilburg University, Center for Economic Research.
  5. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," NBER Technical Working Papers 0282, National Bureau of Economic Research, Inc.
  6. Stephanie Schmitt-Grohe & Martin Uribe, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," NBER Working Papers 10253, National Bureau of Economic Research, Inc.
  7. 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.
  8. 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, vol. 56(3), pages 328-343, April.
  9. Peter N. Ireland, 2004. "Technology Shocks in the New Keynesian Model," NBER Working Papers 10309, National Bureau of Economic Research, Inc.
  10. Kenneth D. West, 1985. "A Variance Bounds Test of the Linear Quardractic Inventory Model," NBER Working Papers 1581, National Bureau of Economic Research, Inc.
  11. Ramey, Valerie A. & West, Kenneth D., 1999. "Inventories," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 13, pages 863-923 Elsevier.
  12. Mark Bils & James A. Kahn, 1999. "What Inventory Behavior Tells Us About Business Cycles," NBER Working Papers 7310, National Bureau of Economic Research, Inc.
  13. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  14. Aubhik Khan, 2003. "The role of inventories in the business cycle," Business Review, Federal Reserve Bank of Philadelphia, issue Q3, pages 38-45.
  15. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2003. "Optimal Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 825-860, October.
  16. Louis J. Maccini & Bartholomew J. Moore & Huntley Schaller, 2004. "The Interest Rate, Learning, and Inventory Investment," American Economic Review, American Economic Association, vol. 94(5), pages 1303-1327, December.
  17. Andrew T. Levin & Alexei Onatski & John C. Williams & Noah Williams, 2005. "Monetary policy under uncertainty in micro-founded macroeconometric models," Working Paper Series 2005-15, Federal Reserve Bank of San Francisco.
  18. Wen, Yi, 2005. "Understanding the inventory cycle," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1533-1555, November.
  19. Alan S. Blinder & Louis J. Maccini, 1991. "Taking Stock: A Critical Assessment of Recent Research on Inventories," Journal of Economic Perspectives, American Economic Association, vol. 5(1), pages 73-96, Winter.
  20. David Lopez-Salido & Andrew T. Levin, 2004. "Optimal Monetary Policy with Endogenous Capital Accumulation," 2004 Meeting Papers 826, Society for Economic Dynamics.
  21. Kryvtsov, Oleksiy & Midrigan, Virgiliu, 2010. "Inventories and real rigidities in New Keynesian business cycle models," Journal of the Japanese and International Economies, Elsevier, vol. 24(2), pages 259-281, June.
  22. 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.
  23. Louis J. Maccini & Adrian Pagan, 2006. "Inventories, Fluctuations and Business Cycles. Working paper #4," NCER Working Paper Series 4, National Centre for Econometric Research.
  24. Martin Boileau & Marc-Andre Letendre, 2011. "Inventories, sticky prices, and the persistence of output and inflation," Applied Economics, Taylor & Francis Journals, vol. 43(10), pages 1161-1174.
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