When Do Inventories Destabilize the Economy? An Analytical Approach to (S,s) Policies

Conventional wisdom has it that inventory investment destabilizes the economy because it is procyclical to sales. Khan and Thomas (2007) show that the conventional wisdom is wrong in a general equilibrium (S,s) model with capital. We argue that their …nding is not robust— the conventional wisdom can still hold in general equilibrium if …rms can adjust output by varying the capacity utilization rate. Our result also holds true if there exist investment adjustment costs. Unlike the existing (S,s) inventory literature that relies on the Krusell-Smith (1998) numerical solution methods, we characterize (S,s) inventory policies in closed form despite the large state space in our general equilibrium model. Standard log-linearization methods can be used to solve the model and generate impulse response functions. Keywords: Inventory Investment, Great Moderation, Business Cycle, Capacity Utilization, (S,s) Policy, State-Dependent Decisions. JEL codes: E13, E22, E32. a: Hong Kong University of Science & Technology; b: Federal Reserve Bank of St. Louis; c: Tsinghua University. Pengfei Wang acknowledges the …nancial support from the Hong Kong Research Grants Council (project #643908). The usual disclaimer applies. Correspondence: Pengfei Wang, Department of Economics, Hong Kong University of Science & Technology, Hong Kong, China. Phone: 852-2358-7612. Email: [email protected].