Inventory Investment and the Real Interest Rate

Sadaquat Junayed,Hashmat Khan

doi:10.5018/economics-ejournal.ja.2009-34

Abstract

Abstract The relationship between inventory investment and the real interest rate has been difficult to assess empirically. Recent work has proposed a linear-quadratic inventory model with time-varying discount factor to identify the effects of the real interest rate on inventory investment. The authors show that this framework does not separately identify the effects of real interest rate on inventory investment from variables that determine the expected marginal cost of production. In other words, the model does not deliver a testable restriction on the impact of interest rates on inventory investment. The authors highlight the consequences for both short- and long-run empirical analyses. They conclude that understanding the relationship between inventory investment and the real interest rate continues to be a theoretical and empirical challenge for macroeconomists.

Highlights

Business reports and financial media often link higher interest rates to lower inventory investment by firms
The academic literature has found little influence, if any, of a relationship between real interest rates and inventories. This discrepancy led Blinder and Maccini (1991) to note that. It is not clear whether the trouble is with the theory or with the empirical tests...Whatever the reason, the question of why inventory investment seems insensitive to changes in real interest rates remains open, important, and troublesome
The implication is that empirical work based on the Euler equation derived from the time-varying real discount factor model is insufficient for understanding the structural relationship between inventory investment and the real interest rate

Summary

Introduction

Business reports and financial media often link higher interest rates to lower inventory investment by firms. In a recent paper, Maccini et al (2004) propose a modified linear-quadratic inventory model with time-varying real discount factor They show that the linearized Euler equation of this model the real interest rate enters with its own coefficient, which is estimated. The implication is that empirical work based on the Euler equation derived from the time-varying real discount factor model is insufficient for understanding the structural relationship between inventory investment and the real interest rate (in either the short- or long-run). It does not offer any particular advantage relative to the earlier literature which used the traditional reduced-form approach

The Model

Effect of Interest Rate

Implications for Empirical Analyses

Conclusion