Inventory Shocks and the Great Moderation

Why did the volatility of U.S. real GDP decline by more than the volatility of final sales with the Great Moderation in the mid-1980s? One explanation is that firms shifted their inventory behavior towards a greater emphasis on production smoothing. We investigate the role of inventories in the Great Moderation by estimating an unobserved components model that identifies inventory and sales shocks and their propagation in the aggregate data. Our estimates provide little support for increased production smoothing. Instead, smaller transitory inventory shocks explain the excess volatility reduction in output relative to sales. These shocks behave like informational errors related to production that must be set in advance and their reduction also helps explain the changed forecasting role of inventories since the mid-1980s. Our findings provide an optimistic prognosis for a continuation of the Great Moderation despite the dramatic movements in output during the recent economic crisis.