Monetary policy and the role of inventory investment

ABSTRACT

In this article, we develop a dynamic stochastic general equilibrium (DSGE) model with sticky prices and inventory investment to explore the relationship between inventories and monetary policy. We use the traditional inventory literature as a basis to motivate this extension of the benchmark model and propose inventories as a factor of production. Within this setting, we test the empirical findings in the literature that, since the mid-1980s, monetary policy changed its target towards the inventory component of GDP. We explore this idea in our theoretical model and conclude through simulations that this is a plausible complementary explanation for the reduction in output volatility that was observed during the Great Moderation period.

KEYWORDS:

• DSGE
• sticky prices
• inventories
• monetary policy
• Great Moderation

JEL CLASSIFICATION:

• E3
• E5

Acknowledgement

We thank Jeff Fuhrer, Fabio Ghironi, Fabia Gumbau, Peter Ireland and Owen Irvine for their advice. Part of this work was made while Margarita Rubio was visiting the Federal Reserve Bank of Boston. She would like to thank their hospitality. All errors are ours. Usual disclaimer applies.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ represents inventory depreciation. Iacoviello, Schiantarelli, and Schuh (2011) note that inventory depreciation helps matching the data when introducing inventories in the production function.

² These models have also been taken to the data in some cases. See, for example Ireland (1997).

³ Derivations are available upon request.

⁴ Consistently with the literature, a demand shock is represented as an additive shock in the Euler equation for consumption.

⁵ This value of corresponds to an annual interest rate of 4%. We consider corresponding to logarithmic utility An elasticity of demand of 6 implies a steady-state markup of 1.2. The value of implies a higher elasticity than what microeconometric studies would suggest but rationalizing the weak observed response of wages to shocks. See Hansen (1985) for a detailed explanation.