Understanding the Inventory Cycle: I. Partial Equilibrium Analysis

Careful examination of aggregate data from the U.S. and other OECD countries reveals that production and inventory behavior exhibit paradoxical features: 1) Inventory investment is strongly countercyclical at very high frequencies (e.g., 2-3 quarters per cycle); it is procyclical only at relatively low cyclical frequencies such as the business-cycle frequencies (e.g., 8-40 quarters per cycle). 2) Production is less volatile than sales around the high frequencies; it is more volatile than sales only around business-cycle or lower frequencies. 3) Unlike capital investment or GDP, the bulk of the variance of inventory investment is concentrated around high frequencies rather than around business-cycle frequencies. These features of production and inventory behavior at the low and high frequencies provide a litmus test for inventory theories. This paper shows that the stockout-avoidance theory (Kahn, AER 1987) has a much better potential than any other competing theories for explaining the seemingly paradoxical features of inventory fluctuations observed at different cyclical frequencies. My analysis suggests that demand shocks are the source of the business cycle.