Abstract
We derive parametric tests for the role of the interest rate in specifications based on the firm's optimization problem. These Euler equation and decision rule tests mirror earlier evidence, finding little role for the interest rate. We present a simple and intuitively appealing explanation, based on regime switching in the real interest rate and learning, of why tests based on the stock adjustment model, the Euler equation, and decision rule - all of which emphasize short-run fluctuations in inventories and the interest rate - are unlikely to uncover a relationship. Our analysis suggests that inventories will not respond much to short-run fluctuations in the interest rate, but they should respond to long-run movements. Both simple and sophisticated tests confirm our predictions and show a highly significant long-run relationship between inventories and the interest rate. A formal model of our explanation yields a previously untested implication that is supported by the data.
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