Aubhik Khan

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

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.

Inflation and Interest Rates With Endogenous Market Segmentation

The authors examine a monetary economy where households incur fixed transactions costs when exchanging bonds and money and, as a result, carry money balances in excess of current spending to limit the frequency of such trades. As only a fraction of households choose to actively trade bonds and money at any given time, the market is endogenously segmented. Moreover, because households in this model economy have the ability to alter the timing of their trading activities, the extent of market segmentation varies over time in response to real and nominal shocks. The authors find that this added flexibility can substantially reinforce both sluggishness in aggregate price adjustment and the persistence of liquidity effects in real and nominal interest rates relative to that seen in models with exogenously segmented markets.

Modeling Inventories Over the Business Cycle

We search for useful models of aggregate fluctuations with inventories. We focus exclusively on dynamic stochastic general equilibrium models that endogenously give rise to inventory investment and evaluate two leading candidates: the (S,s) model and the stockout avoidance model. Each model is examined under both technology shocks and preference shocks, and its performance gauged by its ability to explain the observed magnitude of inventories in the U.S. economy, alongside other empirical regularities such as the procyclicality of inventory investment and its positive correlation with sales. We find that the (S,s) model is far more consistent with the behavior of aggregate inventories in the postwar U.S. when aggregate fluctuations arise from technology, rather than preference, shocks. The converse is true for the stockout avoidance model. Overall, while the (S,s) model performs well with respect to the inventory facts and other business cycle regularities, the stockout avoidance model does not. There, the essential motive for stocks is insufficient to generate inventory holdings near the data without destroying the models performance along other important margins. Finally, the stockout avoidance model appears incapable of sustaining inventories alongside capital. This suggests a fundamental problem in using reduced-form inventory models with stocks rationalized by this motive.

The Pitfalls of Monetary Discretion

In a canonical staggered pricing model, monetary discretion leads to multiple private sector equilibria. The basis for multiplicity is a form of policy complementarity. Specifically, prices set in the current period embed expectations about future policy, and actual future policy responds to these same prices. For a range of values of the fundamental state variable — a ratio of predetermined prices — there is complementarity between actual and expected policy, and multiple equilibria occur. Moreover, this multiplicity is not associated with reputational considerations: it occurs in a two-period model.

The Pitfalls of Discretionary Monetary Policy

In a canonical staggered pricing model, monetary discretion leads to multiple private sector equilibria. The basis for multiplicity is a form of policy complementarity. Specifically, prices set in the current period embed expectations about future policy, and actual future policy responds to these same prices. For a range of values of the fundamental state variable — a ratio of predetermined prices — there is complementarity between actual and expected policy, and multiple equilibria occur. Moreover, this multiplicity is not associated with reputational considerations: it occurs in a two-period model.