Working Paper 07-16
by Matteo Iacoviello, Fabio Schiantarelli, and Scott Schuh

We build and estimate a two-sector (goods and services) dynamic stochastic general equilibrium model with two types of inventories: materials (input) inventories facilitate the production of finished goods, while finished goods (output) inventories yield utility services. The model is estimated using Bayesian methods. The estimated model replicates the volatility and cyclicality of inventory investment and inventory-to-target ratios. Although inventories are an important element of the model’s propagation mechanism, shocks to inventory efficiency or management are not an important source of business cycles. When the model is estimated over two subperiods (pre- and post-1984), changes in the volatility of inventory shocks, or in structural parameters associated with inventories play a minor role in reducing the volatility of output.

JEL Classifications: E22, E32, E37

Keywords: inventories, business cycles, output volatility, Bayesian estimation, Great Moderation

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