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The Role of Inventories
In the Business Cycle
BY AUBHIK KHAN
hanges in the stock of firms’ inventories are INVENTORIES SEEM
an important component of the business TO BE IMPORTANT IN THE
C BUSINESS CYCLE
cycle. In fact, discussion about the timing Figure 1 shows the business-
of a recovery following economic recessions cycle component of real gross domestic
product (GDP) in the United States
often focuses on inventories. Aubhik Khan surveys the over most of the postwar period. We can
facts about inventory investment over the business think of movements in GDP as the sum
of two components: the trend and the
cycle, then discusses two leading theories that may business cycle. The trend represents the
explain these observations. average growth rate of the economy
across surrounding years. The business
cycle reflects short-term deviations from
this trend: the expansions and contrac-
1 2
tions that make up the business cycle. ,
Changes in the stock of firms’ that may explain these observations. For comparison, recessions, as dated by
inventories are an important component Theory that passes the test of observa- the National Bureau of Economic
of the business cycle. Alan Blinder, a tion may allow us, with some confi- Research, are shaded in the figure.
former Governor of the Federal Reserve dence, to predict future movements in The figure also includes
System, famously remarked that “the the data. Theories that have sought to changes in the stock of private nonfarm
business cycle, to a surprisingly large explain macroeconomic changes in inventories (private refers to nongovern-
degree, is an inventory cycle.” Consis- inventory investment have generally ment). The difference between GDP,
tent with this perspective, much of the focused on firms’ attempts to (1) reduce the sum of all goods and services
discussion about the timing of a the costs of adjusting their production produced in the economy over a given
recovery following economic recessions level or (2) reduce the costs of placing period, and final sales, the sum of all
focuses on firms’ stocks of inventories. orders for intermediate goods. While goods and services sold, is known as net
Pundits suggest that production and much of the research on inventories in inventory investment. Net inventory
employment cannot recover until firms’ the past 50 years has emphasized the
inventories fall, relative to their sales. cost of adjusting production, this
This article surveys the facts approach has had well-known difficul-
about inventory investment over the ties when confronted with the data. 1 Actually, any type of expenditure or output
business cycle, then discusses two Recent work that has focused on may be broken down into a business-cycle
component and a trend. The process of
leading theories of inventory investment reducing the fixed costs of ordering isolating the business-cycle component is
goods may provide a framework that is known as “detrending” or “filtering.” The
real quarterly series in the figure have been
more consistent with the facts. At the detrended with the Hodrick-Prescott filter
same time, this recent work may using a smoothing parameter of 1600. For
produce new insights about the additional details, see Edward C. Prescott’s
paper.
Aubhik Khan is a interaction between inventories and the
macroeconomy. These two theories 2 It then follows that a recession, in this
senior economist in approach to business cycles, is a period in
the Research predict different behavior for aggregate which the economy is growing at rates that
Department of the production, sales, and inventory are lower than its trend. This contrasts with
Philadelphia Fed. investment. the conventional use of the term recession to
describe a period of negative growth.
38 Q3 2003 Business Review www.phil.frb.org
investment is a measure of goods that sures the size of the variable’s total that a common view of inventories —
3
have been made but not sold to fluctuation over the business cycle. that they are goods that firms were
consumers nor used by a firm as an Economic variables differ considerably unable to sell — can’t explain most of
intermediate input into production. in their volatility. For example, consump- the movements in inventories. In an
A car made by Honda in Ohio, tion of nondurable goods and services is expansion, inventories grow as consump-
completed but retained unused in the far less volatile than GDP, while business tion and investment grow. That is, when
factory, adds to Honda’s stock of investment and consumption of sales rise, inventories also rise. If
inventories. Steel bought by the same consumer durable goods are more inventories were mainly goods that firms
manufacturer but left unused is a raw volatile — i.e., they have bigger swings. couldn’t sell, they would tend to rise
material that also adds to Honda’s stock Thus, investment fluctuates a lot more when sales fell.
of inventories. Nonfarm private than does the consumption of nondu- By definition GDP = Final
inventories are essentially stocks of these rables and services as output rises and Sales + Net Inventory Investment.
final goods, intermediate inputs, falls. Thus, any change in GDP must be
materials, or supplies held by businesses. Net inventory investment is attributable to either a change in final
Changes in this component of total pro-cyclical (Figure 1). It moves along sales or a change in net inventory
inventory investment account for most with GDP, rising during expansions and investment. Let’s look at the fraction of
of the change in total inventories over falling during recessions. This is a very the change in GDP that can be
the business cycle. important observation because it means accounted for by changes in net
Cyclicality and Volatility. In inventory investment. To accomplish
organizing their thinking about the role this, we divide the change in inventories
of an economic variable such as during recessions by the corresponding
inventory investment over the business 3 Formally, we define volatility as the change in GDP. The result is a number
cycle, economists focus on the cyclicality standard deviation of the business-cycle around one-half. Almost half of the fall
component of the quarterly data.
and volatility of the variable. A
variable’s cyclicality — formally, its
correlation with real GDP — is a
measure of how the variable changes FIGURE 1
over the business cycle. For example, net
exports — that is, exports minus imports GDP, Final Sales, and Changes in Nonfarm In-
— are countercyclical: they fall as GDP ventories
rises during an expansion, and they rise
as GDP declines in a recession.
In contrast, consumption and
investment are pro-cyclical: they rise
during expansions and fall, alongside
GDP, in recessions. A significant
correlation, whether positive or negative,
between any economic variable and
GDP suggests that the variable is
cyclical in that it varies in a systematic
way with GDP over the business cycle.
This is not true of all economic variables.
For example, government spending is
acyclical: it shows no significant
correlation with economy activity over
the business cycle, neither rising nor
falling systematically.
While the cyclicality of a
variable measures the extent to which it
rises or falls with GDP, volatility mea-
www.phil.frb.org Business Review Q3 2003 39
in production experienced by the U.S. THE MYSTERY known as the (S, s) model of inventories,
economy during a recession may be OF INVENTORIES emphasizes the costs of accepting
explained by a reduction in net Economists are not satisfied deliveries. While each of these theories
inventory investment. This is a merely to uncover the facts about can explain why firms hold inventories,
surprisingly large fraction when one inventories and the business cycle. they are commonly applied to different
considers that net inventory investment Their primary goal is to explain these types of inventories. Thus, the two
is, on average, only around 0.5 percent findings. Before we may begin to theories are not mutually exclusive; both
of GDP. It indicates that inventory understand why firms change their may be relevant to an understanding of
investment is extremely volatile. holdings of inventories over the business the overall stock of inventories.
Adding to the Volatility of cycle, we must have an understanding However, as with all science,
Output. The pro-cyclicality and of why firms hold inventories at all. For the empirical relevance of these
extreme volatility of inventory invest- economic theory, this has been more of a alternative theories can be assessed by
ment have led researchers to suggest mystery than you might suppose. evaluating their predictions against the
that inventories are a destabilizing force. Why would a firm produce data. The production-smoothing model
At its simplest, their argument is as goods but not sell them? Sales com- and the (S, s) model generally have
follows. Inventory investment and final pleted today give the firm income that it distinct predictions about the joint
sales tend to move together: both rise may invest. For example, even if the behavior of production, sales, and
during expansions, and both fall during firm has no other immediate use for the inventory investment.
recessions. Consequently, GDP varies funds, it might deposit them in an
by more than it would if inventory interest-earning account. A firm would THE PRODUCTION-
investment were constant or negatively forgo this interest income if it chooses SMOOTHING MODEL
correlated with final sales. not to sell its goods immediately. The production-smoothing
To understand this better, But perhaps it isn’t voluntary. model explains why a manufacturing
consider the following simple example. If You may think firms hold inventories firm holds stocks of goods produced but
final sales rise during odd years and fall only of finished goods they have been unsold. The model assumes that it is
during even years, while inventory unable to sell. While firms do sometimes costly for the manufacturing firm to
investment rises (by the same amount) accumulate inventories of unsold goods adjust production.
during even years and falls during odd because of weaker-than-expected It is costly to buy and install
years, there’s no effect on GDP. demand, this can’t be the central new equipment or to uninstall and sell
Inventory investment and final sales explanation of inventory holdings. First, off previously installed equipment.
move in opposite directions; they are remember that inventories rise when Workers are costly to hire and train, and
negatively correlated. As a result, each sales do. Second, goods that have been layoffs are also expensive. Since chang-
offsets the change in the other. Produc- produced but not yet sold are only a ing levels of output often involve
tion is smoothed. fraction of the total stock of inventories. changing the size of the labor force and
Now, consider an alternative Firms also hold inventories of inputs they purchasing new capital equipment,
case in which both series rise during odd use to produce their goods, buying them these adjustment costs are inevitable for a
years. Since inventory investment moves before they need them. firm that changes its level of output over
with output, and since it’s highly The answer to the question of time. It’s reasonable to assume that these
volatile, inventories substantially raise why firms forgo interest income must costs of changing production levels
the volatility of GDP. Since final sales involve benefits derived from holding actually increase with the size of the
and inventory investment are indeed inventories. Holding stocks of invento- change. For example, a large increase in
positively correlated, typically rising and ries must somehow reduce a firm’s cost production requires hiring more workers
falling at the same time, researchers of production, and these cost savings and, thus, involves higher training costs.
have concluded that inventories are a must exceed the forgone interest. In any case, given these costs of adjust-
destabilizing force in the economy. (See There are two theories of how ing production, if sales are volatile, a
Are Inventories Becoming Less Promi- production costs induce firms to hold firm may prefer not to vary production
nent?) Changes in inventories magnify stocks of inventories. The first, known to match the variation in sales. Instead,
the effect of a change in final sales on as the production-smoothing model of it may use inventories of already
domestic production. inventories, emphasizes the costs of produced goods to offset the difference
adjusting production. The second, between production and sales.
40 Q3 2003 Business Review www.phil.frb.org
ARE INVENTORIES BECOMING LESS PROMINENT?
If inventories are indeed a destabilizing element intermediate inputs and materials and supplies, both
of aggregate economic activity, perhaps the much heralded components of the overall stock of inventories but not part
improvements in technology that have led to sharp declines of final sales, must account for the divergence between the
in the inventory to sales ratio will eventually yield a less real and nominal ratios of inventories to sales.
severe business cycle. Since inventories seem to explain so While I cannot suggest which ratio is more
much of the decline in output during recessions, and since sensible, Figure 2 casts some doubt on some of the discus-
they amplify the effect of changes in final sales on GDP, as sion of technological improvements’ role in reducing
inventory levels decline, perhaps GDP will be subject to less demand for inventories. While both the financial press and
severe fluctuations. policymakers have repeatedly mentioned the important
Arguments such as this have led economists to role of improved management techniques, such as just-in-
emphasize the decline in the inventory to sales ratio. In time production methods, in reducing firms’ dependence
Figure 2, we see the nominal stock of inventories as a ratio on inventories, the real inventory to sales ratio in Figure 2
of final sales. Clearly, it has declined sharply since the early suggests caution before making sweeping generalizations.
1980s. Many observers have regarded this decline as the When examining the nominal inventory to sales ratio, we
result of improvements in technology and management see that it rose before it fell, something that is hard to
methods that have allowed firms to reduce their holdings explain using technological improvement. The real ratio
of inventories relative to their sales. This is less clear from has not declined consistently over the past 20 years.
the figure. First, we see that the
inventory to sales ratio rose sharply
in the 1970s. If technological FIGURE 2
innovation has reduced the ratio
since the 1980s, what was the sharp Quarterly Nominal and Real Inventory
technological regress in the 1970s? to Sales Ratios
Second, and related, is the finding
that the inventory to sales ratio was
as low in the late 1960s as it was in
the mid 1980s.
Even the decline in the
importance of inventories is less clear
than is commonly acknowledged.
The figure also plots the real
inventory to sales ratio, that is, the
ratio when both inventories and
sales figures have been divided by
their price indexes. While the
nominal inventory to sales ratio
shows a clear negative trend over
the past 20 to 25 years, the real
inventory to sales ratio displays no
corresponding decline! This implies
that the price index for inventories
has fallen more slowly than that for
final sales. It would seem that
changes in the relative price of
www.phil.frb.org Business Review Q3 2003 41
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