What Inventories Tell Us About Aggregate Fluctuations - A Tractable Approach to (S,s) Policies

Abstract

We estimate a DSGE model with (S,s) inventory policies. We find that (i) taking inventories into account can significantly improve the empirical fit of DSGE models in matching the standard business-cycle moments (in addition to explaining inventory fluctuations); (ii) (S,s) inventory policies can significantly amplify aggregate output fluctuations, in contrast to the findings of the recent general-equilibrium inventory literature; and (iii) aggregate demand shocks become more important than technology shocks in explaining the business cycle once inventories are incorporated into the model. An independent contribution of our paper is that we develop a solution method for analytically solving (S,s) inventory policies in general-equilibrium models with heterogeneous firms and a large aggregate state space, and we illustrate how standard log-linearization methods can be used to solve various versions of our inventory model, generate impulse response functions, and estimate the model’s deep structural parameters.