Staff Reports

Inventory Dynamics and Business Cycles: What Has Changed?

December 2002  Number 156
JEL classification: E32, E22, D24

Authors: Jonathan McCarthy and Egon Zakrajšek

By historical standards, the U.S. economy has experienced a period of remarkable stability since the mid-1980s. One explanation attributes the diminished variability of economic activity to information-technology-led improvements in inventory management. Our results, however, indicate that the changes in inventory dynamics since the mid-1980s played a reinforcing—rather than a leading—role in the volatility reduction. A decomposition of the reduction in the volatility of manufacturing output shows that it almost entirely reflects a decline in the variance of the growth contribution of shipments. And although the volatility of total inventory investment has fallen, the decline occurred well before the mid-1980s and was driven by the reduced variability of materials and supplies. Our analysis does show that since the mid-1980s, inventory dynamics have played a role in stabilizing manufacturing production: Inventory 'imbalances' are corrected more rapidly, and the quicker response of inventories to aggregate shocks—at all stages of fabrication—buffers production from fluctuations in sales to a greater extent. But more extensive production smoothing and faster dissolution of inventory imbalances appear to be a consequence of changes in the way industry-level sales and aggregate economic activity respond to shocks, rather than a cause of changes in macroeconomic behavior.

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For a published version of this report, see Jonathan McCarthy and Egon Zakrajšek, "Inventory Dynamics and Business Cycles: What Has Changed?" Journal of Money, Credit, and Banking 39, no. 2-3
(March-April 2007): 591-613.