Inventories, Interest Rates, and Markups

David G Bivin

doi:10.4236/tel.2011.12010

Abstract

This note explains why inventories might rise with interest rates. Higher real interest rates not only increase the carrying cost of inventories they also reduce the present value of the markup on delayed sales. When the markup is large enough, it is profitable to increase stocks in order to avoid sales delays. Another possibility is that the firm has an incentive to smooth its total stocks so that an increase in the real interest rate causes finished goods to fall but the reduction is partially offset by an increase in raw materials.

Highlights

Higher real interest rates increase the carrying cost of inventories they reduce the present value of the markup on delayed sales
When the markup is large enough, it is profitable to increase stocks in order to avoid sales delays. Another possibility is that the firm has an incentive to smooth its total stocks so that an increase in the real interest rate causes finished goods to fall but the reduction is partially offset by an increase in raw materials
An enduring puzzle in the inventory literature is that inventories do not appear to decline when the real interest rate rises

Summary

Introduction

An enduring puzzle in the inventory literature is that inventories do not appear to decline when the real interest rate rises. Maccini, Moore, and Schaller [2] developed an innovative test for a long-run inverse relationship between the interest rate and finished goods inventories in the context of the linear quadratic model. It is shown here that adding a carrying cost of finished goods to the model causes the firm's safety stock to rise as the real interest rate rises. A third model demonstrates why raw materials might rise in the context of a linear-quadratic model with inventtories of both finished goods and raw materials In this case, the increase is due to an effort to smooth total stocks. Where S is sales, Q is demand, X is output, and F is the end-of-period stock of finished goods. The firm has an incentive to raise its safety stock as a means of economizing on this penalty

Production to Order3

Multi-Stage Stocks in the Linear- Quadratic Model5

Findings

Conclusions