Inventory Investment - Inventory Investment Over The Business Cycle

Inventory Investment Over The Business Cycle

A typical business cycle plays out in the following way. Starting from some point in the business cycle, some group (consumers, government, purchasers of exports, etc.) decides for some reason to have a sustained increase in their spending. This may come as a surprise to producers, who initially experience negative inventory investment as their sales have unexpectedly exceeded their production. Now their inventories are too low, for two reasons: (1) Inventories have accidentally gone down, and (2) the optimal level of inventories—what producers want to have on hand—has gone up because sustained customer demand has gone up and there is increased danger of temporary stock-outs. In order to build inventories up to an appropriate level, firms engage in positive intended inventory investment. This positive flow of intended inventory investment continues until the target level of inventories is reached. During this time, the economy is in a boom both due to the original sustained increase in spending and due to the positive flow of intended inventory investment.

At some point, there is a sustained decline in some type of spending for some reason. (One reason may simply be that, once inventories reach their desired level, there stops being positive intended inventory investment; but there may be other reasons as well.) Then there is positive unintended inventory investment as firms are caught by surprise by the external drop in demand and they fail to simultaneously lower their production. Now inventories are too high, for two reasons: (1) They have accidentally risen, and (2) the optimal level of inventories is lower now due to the new, lower level of sustained demand. So in order to lower their inventories, forms deliberately cut back their production to below the level of demand by their customers, thus causing inventories to be deliberately drawn down—that is, intended inventory investment is negative. Intended inventory investment remains negative until the target level of inventories is reached. During this time, the economy, having peaked out, is in a downturn (a recession) both due to the sustained decrease in non-inventory expenditure and due to the negative flow of intended inventory investment.

At some point, there is a sustained increase in some type of spending for some reason. (One reason may simply be that, once inventories sink to their desired level, there stops being negative intended inventory investment, which goes up from negative to zero; but again there may be other reasons as well.) At this point there is negative unintended inventory investment as firms are caught by surprise by the external increase in demand and they fail to simultaneously raise their production. Now inventories are too low, again for two reasons, and we are back where we started in the cycle. The recession has bottomed out, sustained spending is once again high, target inventory levels are higher than actual inventory levels, and intended inventory investment is positive.