NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Inventories and the Business Cycle: An Equilibrium Analysis of (S,s) Policies

Aubhik Khan, Julia Thomas

NBER Working Paper No. 10078
Issued in November 2003
NBER Program(s):   EFG

We develop an equilibrium business cycle model where nonconvex delivery costs lead producers of final goods to follow generalized (S,s) inventory policies with respect to intermediate goods. When calibrated to match the average inventory-to-sales ratio in postwar U.S. data, our model reproduces two-thirds of the cyclical variability of inventory investment. Moreover, inventory accumulation is strongly procyclical, and production is more volatile than sales, as in the data. The comovement between inventory investment and final sales is often interpreted as evidence that inventories amplify aggregate fluctuations. Our model contradicts this view. Despite the positive correlation between sales and inventory investment, we find that inventory accumulation has minimal consequence for the cyclical variability of GDP. In equilibrium, procyclical inventory investment diverts resources from the production of final goods; thus, it dampens cyclical changes in final sales, leaving GDP volatility essentially unaltered. Moreover, although business cycles arise solely from shocks to productivity and markets are perfectly competitive in our model, it nonetheless yields a countercyclical inventory-to-sales ratio.

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This paper was revised on February 1, 2007

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Document Object Identifier (DOI): 10.3386/w10078

Published: Aubhik KhanJulia Thomas. “Inventories and the Business Cycle: An Equilibrium Analysis of (S,s) Policies." American Economic Review 97, 4 (2007): 1165-88.

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