Inventory dynamics, asset prices and business cycles

Abstract

The thesis has three main papers. The first paper presents a model of inventory dynamics to explain the sign puzzle - the positive relationship that is often found between inventories and interest rates. Firstly, the study updates the empirical evidence on the puzzle in the United States, Canada and South Africa by means of a log linear inventory model and an inventory growth model. The empirical results reveal that the positive effect of interest rates on inventories still exists in the United States and Canada, especially in the data sample period that precedes the global financial crisis of 2007-2009. However, the study finds no evidence-in support of the sign puzzle in South Africa. Secondly, the theoretical analysis of the structural model that we develop in this study reveals that the sign puzzle is mainly driven by the elasticity of benefits for inventory holding sand the sensitivity of stockouts cost to changes in the cost of capital. The second paper shows that the New Keynesian dynamic stochastic general equilibrium (NK DSGE) model which incorporates inventory dynamics can generate a hump-shaped response of macro variables to shocks, even without habit-formation. Furthermore, we find that only a moderate level of price indexation, far below those normally estimated at the macro level, is needed to generate a gradual response of inflation to a monetary policy shock. More-over, the model replicates stylized facts about inventory dynamics, such as the procyclicality of inventories and the countercyclical nature of inventory-sales ratio. Finally, the results are robust to variations in the probability of price stickiness and the inventory adjustment cost parameter. The third paper shows that adding inventory dynamics rather than habit formation to a small open New Keynesian dynamic stochastic general equilibrium (NK DSGE) model, amplifies the immediate response of asset prices to a monetary policy shock. Specifically, and without the financial accelerator effect, a 100 basis-point increase in the nominal interest rate leads the stock price to decline by 17:06% in the model with inventories and the stock price declines by 4:38% in the model without inventories. The results suggest that inventories magnify the financial accelerator effect and habit formation reduces the amplifying role of inventories. The model also replicates a procyclical response in inventories and a countercyclical response in the inventory-sales ratio and the equity premium. In summary, the first paper provides a solution to the sign puzzle and the second paper shows that inventories play the role of habit formation in a New-Keynesian DSGE model. The third paper reveals that the response of asset prices in macro-finance models without inventories could be underestimated