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BOK Working Paper No.2018-7, Inventory Investments and Business Cycles

Economic Research Institute (+82-2-759-5411) 2018.03.08 6217

Title : Inventory Investments and Business Cycles

Author : Seo, Byeongseon (Korea University), Jang, Keunho(BOK)


According to the production smoothing hypothesis of inventory investment, firms hold inventories to cope with unexpected changes in demand under the convexity of production costs. Thus, if the hypothesis holds, the volatility of production would be lower than that of demand. However, the production smoothing hypothesis is inconsistent with the empirical regularity that the variability of production is not small compared to that of demand but rather large. To examine the determinants of inventory investment, we conducted a micro-dynamic analysis using the micro-level corporate panel data. The inventory changes induced by the production smoothing hypothesis cannot be supported by the result, while stock-out avoidance behavior is significant. Also, we found that inventory investments have close relationships with corporate profits or cash flows that are strongly pro-cyclical. In the macro-dynamic analysis, we derived two long-run equilibria from the relationship between inventories and sales, and between output and sales. Having analyzed the dynamic properties of inventory investments, we found that the dynamics are dependent on business cycles. During booms, the volatility of inventory investments is amplified due to stock-out avoidance motive, while production smoothing is insignificant. In contrast, during recessions, the non-convexity of production costs amplifies the volatility of inventories, while stock-out avoidance motive is insignificant. We found that the accuracy of business cycle forecasting could be improved by utilizing the dependence of inventory investment dynamics on the business cycle.