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Macroeconomics
ECO 403
VU
LESSON
43
INVESTMENT
(Continued...)
Inventory
Investment
·
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, yet
its volatility makes it
critical in the
study
of economic fluctuations.
·
In
recession, firms stop
replenishing their inventory as
goods are sold, and
inventory
investment
becomes negative.
1.
When
sales are high, the
firm produces less that it
sells and it takes the
goods out
of
inventory. This is called
production
smoothing.
2.
Holding
inventory may allow firms to
operate more efficiently.
Thus, we can view
inventories
as a factor of production.
3.
Also,
firms don't want to run
out of goods when sales
are unexpectedly high. This
is
called
stock-out
avoidance.
4.
Lastly,
if a product is only partially
completed, the components
are still counted in
inventory,
and are called, work in
process.
Seasonal
Fluctuation and Production
Smoothing
·
Contrary to
the expectations of many
economists and researchers,
firms do not use
inventories
to smooth production over
time.
·
The
clearest evidence comes from
industries with seasonal
fluctuations in demand. e.g.
fan
manufacturing.
One would expect that
firms would build up
inventories in times f low
sales
and
draw them down in times of
high sales.
·
Yet in most
industries firm do not use
inventories to smooth production
over the year,
rather
seasonal
pattern matches seasonal
pattern in sales.
The
Accelerator Model of
Inventories
The
accelerator
model assumes
that firms hold a stock of
inventories that is proportional
to
the
firm's level of
output.
When
output is high, manufacturing
firms need more materials
and supplies on hand,
and
more
goods in process of
completion.
When
Economy is booming, retail
firms want to have more
merchandise on their shelves
to
show
customers.
·
Thus, if N
is the economy's stock of
inventories and Y is output,
then
N=βY
where
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 βN.
·
Therefore,
I
= ΔN
= β ΔY
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.
The
model says that inventory
investment depends on whether
the economy is speeding up
or
slowing
down.
198
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Macroeconomics
ECO 403
VU
Inventories
and the Real Interest
Rate
·
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.
·
When
the 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.
199