Models and Measurement: (S,s) Inventories and Investment Under Adjustment Costs

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This proposal includes two projects exploring the relation between adjustment costs and investment. Each uses new models and methods to examine questions central to understanding how the economy changes over time. The first project, joint with Aubhik Khan of the Federal Reserve Bank of Philadelphia, considers the question: "Do inventories exacerbate the business cycle?" It examines the aggregate implications of endogenous generalized (S,s) inventory investment, focusing on inventories of intermediate goods in a dynamic stochastic general equilibrium model with capital accumulation. First, the model's ability to reproduce observed cyclical relations between inventory investment, final sales and production is assessed. Next, the effects of such inventories for the overall business cycle are studied. The second project considers, "How do differing assumptions about firms' discount rates influence structural estimates of capital adjustment costs?" It explores a researcher's ability to estimate adjustment costs and explain the volatility and persistence of investment fluctuations under varying assumptions about the relation between the process governing shocks to firms' profits and that governing their intertemporal profit valuations. Both projects involve considerable heterogeneity across plants. This makes the determination of equilibrium prices difficult, due to the standard feedback of decision rules through prices. Equilibrium prices are solved by allowing agents' to forecast the future state using a subset of the aggregate state vector. Firms' decision rules, which are highly nonlinear, are solved using multivariate spline interpolation.Intellectual Merits: The topic of inventories has long been prominent in discussions of the business cycle, yet it has been largely ignored by modern business cycle theory. Most macroeconomic inventory research has focused on linear quadratic representative firm models that are partial equilibrium by design and generally disappointing in their empirical predictions. By contrast, the leading microeconomic model of inventories, the (S,s) model originally solved by Scarf (1960), has received almost no macroeconomic attention. The project corrects this important omission.Broader Impacts: The research may substantially alter policymakers' understanding of the role of inventories in aggregate fluctuations. For example, preliminary results suggest that recent advances in inventory management, in reducing the size of average stocks, may be responsible for dampened business cycles. When these stocks arise from nonconvex ordering or delivery costs, a reduction in such frictions that leads to reduced average inventory-sales ratios and dampened fluctuations in inventory investment may actually raise the overall volatility in GDP, because reduced inventory accumulation is accompanied by larger fluctuations in final sales.