Staff Report 343

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Modeling Inventories Over The Business Cycle

Aubhik Khan
Julia Thomas

Published August 1, 2004

Abstract
We evaluate two leading models of aggregate fluctutations with inventories in general equilibrium: the (S,s) model and the stockout avoidance model. Each is judged 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 holds for the stockout avoidance model. The (S,s) model performs well with respect to the inventory facts and other business cycle regularities. By contrast, the essential risk motive in the stockout avoidance model is insufficient to generate inventory holdings near the data without destroying the model’s performance elsewhere, suggesting a fundamental problem in using reduced-form inventory models with stocks rationalized by this motive.


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