RDP 9306: Inventories and the Business Cycle 5. Summary and Conclusions

In this paper we examine the interaction of the inventory cycle and the business cycle. In particular we discuss the influences driving the inventory cycle and the impact that inventory investment has on the business cycle. These issues are examined with the aid of both macro-economic data and data from surveys of individual firms.

In contrast to an increasing volume of literature supporting the view that changes in inventories are driven by shocks to the cost of production, we find that demand factors dominate. Using survey data rather than macro-economic data we show that unexpected increases in inventories have typically been associated with unexpectedly low demand. In contrast, when demand is expected to be low, inventories are expected to fall, not rise. This suggests that shocks to demand are viewed as having a considerable degree of persistence and/or that production smoothing is relatively unimportant. Further, changes in real unit costs of production appear to have little independent effect on the inventory cycle. In terms of the debate concerning the sources of business cycle shocks, these results provide considerably more support for models that focus on demand shocks than for models which emphasise shocks to the production function.

Perhaps more importantly, the results also show a significant change in the behaviour of inventories over the last decade. In the business cycles in the 1960s and 1970s, unexpected falls in demand led to a substantial increase in inventories. This was followed by a cut-back in production as firms attempted to wind back the excessively high level of inventories. As a result, the inventory cycle amplified the business cycle.

More recently, unexpected changes in demand have come to play a much smaller role in explaining the behaviour of inventories. The notion that production smoothing is very important and that firms use inventories to buffer production from changes in sales does not appear to be a good description of reality. Increasingly, inventories move positively in line with expected and actual changes in demand. In part, this reflects increasingly sophisticated inventory management techniques and greater production flexibility. The fact that firms can more effectively prevent unintended inventory accumulation in the face of adverse shocks, reduces the need for firms to subsequently cut back production to run down inventories. The reduction in the stocks to sales ratio has also made inventories less sensitive to demand shocks. The result of these changes is an inventory cycle which has a much smaller amplitude and a smaller impact on the output cycle.