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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 can come from a decline in inventory investment.

Inventories serve many purposes. Before presenting a model to explain fluctuations in inventory investment, let’s discuss 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 steps in production 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.

Because there are many motives for holding inventories, there are many models of inventory investment. One simple model that explains the data well, without endorsing a particular motive, is the accelerator model. This model was developed about sixty years ago, and it is sometimes applied to all types of investment. Here we apply it to the type for which it works best—inventory investment.

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The accelerator model of inventories assumes that firms hold a stock of inventories that is proportional to the firms’ level of output. There are various reasons for this assumption. When output is high, manufacturing firms need more materials and supplies on hand, and they have more goods in the process of being completed. When the economy is booming, retail firms want to have more merchandise on the shelves to show customers. Thus, if N is the economy’s stock of inventories and Y is output, then

N = βY,

where β is a parameter reflecting how much inventory firms wish to hold as a proportion of output.

Inventory investment I is the change in the stock of inventories ΔN. Therefore,

I = ΔN = βΔY.

The accelerator model predicts that inventory investment is proportional to the change in output. When output rises, firms want to hold a larger stock of inventory, so inventory investment is high. When output falls, firms want to hold a smaller stock of inventory, so they allow their inventory to run down, and inventory investment is negative.

We can now see how the model earned its name. Because the variable Y is the rate at which firms are producing goods, ΔY is the “acceleration” of production. The model says that inventory investment depends on whether the economy is speeding up or slowing down.

The accelerator mechanism is one of the reasons that business cycles develop momentum and are therefore so difficult to control. We can appreciate this fact by considering the following scenario and applying the accelerator to all components of investment. Suppose that the economy is at its natural level and that a loss in export sales then reduces GDP and causes a recession. The fact that output has fallen (ΔY is negative) means that investment falls. This makes the recession more severe. Then, when the economy is recovering (ΔY is positive), investment rises. This fact forces the economy to overshoot the natural level (since ΔY is positive at that point, and that keeps investment high). As time proceeds, the (positive) changes in output get smaller, and this pushes investment lower. The fall-off in investment is what causes the next recession. Thus, it is quite likely that a onetime shock like a drop in export sales can set in motion a whole series of overshoots—an ongoing business cycle—because of the accelerator mechanism.

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 this 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 credit crisis of 2008, for example, firms reduced their inventory holdings substantially. As in many economic downturns, the decline in inventory investment was a key part of the overall decline in aggregate demand.