What Inventories Tell Us about Aggregate Fluctuations — A Tractable Approach to (S,s) Policies

We estimate a DSGE model with (S,s) inventory policies. We …nd that (i) taking inventories into account can signi…cantly improve the empirical …t of DSGE models in matching the standard business-cycle moments (in addition to explaining inventory ‡uctuations); (ii) (S,s) inventory policies can signi…cantly amplify aggregate output ‡uctuations, in contrast to the …ndings of the recent general-equilibrium inventory literature; and (iii) aggregate demand shocks become more important than technology shocks in explaining the business cycle once inventories are incorporated into the model. An independent contribution of our paper is that we develop a solution method for analytically solving (S,s) inventory policies in general-equilibrium models with heterogeneous …rms and a large aggregate state space, and we illustrate how standard log-linearization methods can be used to solve various versions of our inventory model, generate impulse response functions, and estimate the model’s deep structural parameters. Keywords: (S,s) Inventories Policy, State-Dependent Decisions, HeterogeneousAgent Models, Perturbation Methods. JEL codes: E13, E22, E32. a: Hong Kong University of Science and Technology; b: Federal Reserve Bank of St. Louis and Tsinghua University; c: Antai College of Economics and Management, Shanghai Jiao Tong University. Corresponding author: Pengfei Wang, Department of Economics, Hong Kong University of Science and Technology, Hong Kong, China. Phone: 852-2358-7612. Email: [email protected]. We thank the editor, two anonymous referees, and seminar participants at various institutions for very valuable comments. Pengfei Wang acknowledges the …nancial support from Hong Kong Research Grants OCGA (project #RPC11BM05). The usual disclaimer applies.