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Inventories and Optimal Monetary Policy

  • Thomas A. Lubik

    ()

  • Wing Leong Teo

    ()

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://cbe.anu.edu.au/research/papers/camawpapers/Papers/2010/Lubik_Teo_072010.pdf
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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. 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.
  2. 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.
  3. James A. Kahn & Mark Bils, 2000. "What Inventory Behavior Tells Us about Business Cycles," American Economic Review, American Economic Association, vol. 90(3), pages 458-481, June.
  4. 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.
  5. Noah Williams & Andrew Levin & Alexei Onatski, 2005. "Monetary Policy under Uncertainty in Micro-Founded Macroeconometric Models," Computing in Economics and Finance 2005 478, Society for Computational Economics.
  6. West, Kenneth D, 1986. "A Variance Bounds Test of the Linear Quadratic Inventory Model," Journal of Political Economy, University of Chicago Press, vol. 94(2), pages 374-401, April.
  7. Peter N. Ireland, 2002. "Technology Shocks in the New Keynesian Model," Boston College Working Papers in Economics 536, Boston College Department of Economics.
  8. 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.
  9. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Solving dynamic general equilibrium models using a second-order approximation to the policy function," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 755-775, January.
  10. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2003. "Optimal Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 825-860.
  11. Christiano, Lawrence J., 1988. "Why does inventory investment fluctuate so much?," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 247-280.
  12. Jonas D. M. Fisher & Andreas Hornstein, 2000. "(S, s) Inventory Policies in General Equilibrium," Review of Economic Studies, Oxford University Press, vol. 67(1), pages 117-145.
  13. Oleksiy Kryvtsov & Virgiliu Midrigan, 2009. "Inventories and Real Rigidities in New Keynesian Business Cycle Models," Staff Working Papers 09-9, Bank of Canada.
  14. Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Optimal Simple and Implementable Monetary and Fiscal Rules," CEPR Discussion Papers 4334, C.E.P.R. Discussion Papers.
  15. Wen, Yi, 2002. "Understanding the Inventory Cycle," Working Papers 02-04, Cornell University, Center for Analytic Economics.
  16. David Lopez-Salido & Andrew T. Levin, 2004. "Optimal Monetary Policy with Endogenous Capital Accumulation," 2004 Meeting Papers 826, Society for Economic Dynamics.
  17. 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.
  18. Jung, YongSeung & Yun, Tack, 2005. "Monetary Policy Shocks, Inventory Dynamics, and Price-Setting Behavior," Santa Cruz Department of Economics, Working Paper Series qt3sf4q6nn, Department of Economics, UC Santa Cruz.
  19. 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.
  20. Aubhik Khan, 2003. "The role of inventories in the business cycle," Business Review, Federal Reserve Bank of Philadelphia, issue Q3, pages 38-45.
  21. 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.
  22. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  23. 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, vol. 54(3), pages 706-727, April.
  24. Louis J. Maccini & Adrian Pagan, 2006. "Inventories, Fluctuations and Business Cycles. Working paper #4," NCER Working Paper Series 4, National Centre for Econometric Research.
  25. Jonas D. M. Fisher & Andreas Hornstein, 2000. "(S, s) Inventory Policies in General Equilibrium," Review of Economic Studies, Oxford University Press, vol. 67(1), pages 117-145.
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