Inventory investment—the goods that businesses put aside in storage—is at the same time negligible and of great significance. It is one of the smallest components of spending, averaging about 1 percent of GDP. Yet its remarkable volatility makes it central to the study of economic fluctuations. In recessions, firms stop replenishing their inventory as goods are sold, and inventory investment becomes negative. In a typical recession, more than half the fall in spending comes from a decline in inventory investment.
Inventories serve many purposes. Let’s discuss in broad terms some of the motives firms have for holding inventories.
One use of inventories is to smooth the level of production over time. Consider a firm that experiences temporary booms and busts in sales. Rather than adjusting production to match the fluctuations in sales, the firm may find it cheaper to produce goods at a steady rate. When sales are low, the firm produces more than it sells and puts the extra goods into inventory. When sales are high, the firm produces less than it sells and takes goods out of inventory. This motive for holding inventories is called production smoothing.
A second reason for holding inventories is that they may allow a firm to operate more efficiently. Retail stores, for example, can sell merchandise more effectively if they have goods on hand to show to customers. Manufacturing firms keep inventories of spare parts to reduce the time that the assembly line is shut down when a machine breaks. In some ways, we can view inventories as a factor of production: the larger the stock of inventories a firm holds, the more output it can produce.
A third reason for holding inventories is to avoid running out of goods when sales are unexpectedly high. Firms often have to make production decisions before knowing the level of customer demand. For example, a publisher must decide how many copies of a new book to print before knowing whether the book will be popular. If demand exceeds production and there are no inventories, the good will be out of stock for a period, and the firm will lose sales and profit. Inventories can prevent this from happening. This motive for holding inventories is called stock-out avoidance.
A fourth explanation of inventories is dictated by the production process. Many goods require a number of production steps and, therefore, take time to produce. When a product is only partly completed, its components are counted as part of a firm’s inventory. These inventories are called work in process.
Like other components of investment, inventory investment depends on the real interest rate. When a firm holds a good in inventory and sells it tomorrow rather than selling it today, it gives up the interest it could have earned between today and tomorrow. Thus, the real interest rate measures the opportunity cost of holding inventories.
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When the real interest rate rises, holding inventories becomes more costly, so rational firms try to reduce their stock. Therefore, an increase in the real interest rate depresses inventory investment. For example, in the 1980s many firms adopted “just-in-time” production plans, which were designed to reduce the amount of inventory by producing goods just before sale. The high real interest rates that prevailed during most of that decade are one possible explanation for this change in business strategy.
Inventory investment also depends on credit conditions. Because many firms rely on bank loans to finance their purchases of inventories, they cut back when these loans are hard to come by. During the financial crisis of 2008–2009, for example, firms reduced their inventory holdings substantially. Real inventory investment, which had been $72 billion in 2006, fell to negative $34 billion in 2008 and negative $148 billion in 2009. It then returned to positive $58 billion in 2010, as the financial system and economy started to recover. During this severe recession, as in many economic downturns, the decline in inventory investment was a key part of the decline in aggregate demand.