The Role of Inventories In the Business Cycle BY AUBHIK KHAN hanges in the stock of firms’ inventories are INVENTORIES SEEM TO BE IMPORTANT IN THE an important component of the business BUSINESS CYCLE C Figure 1 shows the business- cycle. In fact, discussion about the timing cycle component of real gross domestic of a recovery following economic recessions product (GDP) in the United States often focuses on inventories. Aubhik Khan surveys the over most of the postwar period. We can think of movements in GDP as the sum facts about inventory investment over the business of two components: the trend and the cycle, then discusses two leading theories that may business cycle. The trend represents the average growth rate of the economy explain these observations. across surrounding years. The business cycle reflects short-term deviations from this trend: the expansions and contrac- tions that make up the business cycle.1,2 For comparison, recessions, as dated by Changes in the stock of firms’ that may explain these observations. the National Bureau of Economic inventories are an important component Theory that passes the test of observa- Research, are shaded in the figure. of the business cycle. Alan Blinder, a tion may allow us, with some confi- The figure also includes former Governor of the Federal Reserve dence, to predict future movements in changes in the stock of private nonfarm System, famously remarked that “the the data. Theories that have sought to inventories (private refers to nongovern- business cycle, to a surprisingly large explain macroeconomic changes in ment). The difference between GDP, degree, is an inventory cycle.” Consis- inventory investment have generally the sum of all goods and services tent with this perspective, much of the focused on firms’ attempts to (1) reduce produced in the economy over a given discussion about the timing of a the costs of adjusting their production period, and final sales, the sum of all recovery following economic recessions level or (2) reduce the costs of placing goods and services sold, is known as net focuses on firms’ stocks of inventories. orders for intermediate goods. While inventory investment. Net inventory Pundits suggest that production and much of the research on inventories in 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- 1 about inventory investment over the ties when confronted with the data. Actually, any type of expenditure or output may be broken down into a business-cycle business cycle, then discusses two Recent work that has focused on component and a trend. The process of leading theories of inventory investment reducing the fixed costs of ordering isolating the business-cycle component is known as “detrending” or “filtering.” The goods may provide a framework that is 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 additional details, see Edward C. Prescott’s produce new insights about the paper. interaction between inventories and the Aubhik Khan is a 2 It then follows that a recession, in this senior economist in macroeconomy. These two theories 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. the conventional use of the term recession to investment. 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 — have been made but not sold to fluctuation over the business cycle.3 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 3 inventory investment over the business Formally, we define volatility as the change in GDP. The result is a number standard deviation of the business-cycle cycle, economists focus on the cyclicality component of the quarterly data. around one-half. Almost half of the fall and volatility of the variable. A variable’s cyclicality — formally, its correlation with real GDP — is a measure of how the variable changes over the business cycle. For example, net FIGURE 1 exports — that is, exports minus imports GDP, Final Sales, and Changes in Nonfarm In- — are countercyclical: they fall as GDP rises during an expansion, and they rise ventories 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.