Empirical and theoretical aspects of inventory behavior became hot topics in the 1950s and early 1960s. No one seemed to notice the tension that was developing between the emerging macroeconomic and microeconomic views of inventories. Macroeconomists routinely thought of inventories as a destabilizing factor, yet the prevailing micro theory viewed inventories as a stabilizing factor. It was a fascinating question that was barely explored. Instead somewhat inexplicably, interest in inventories dried up, as if inventories were of minor economic significance and little intrinsic interest. By the early 1980s, then, economists once again knew something they had known in the 1950s: that inventory investment is of first-order importance in business cycles. But they were also beginning to realize that the standard production-smoothing/buffer-stock model of inventories was in deep trouble. This paper focuses on developments since that realization.

Recent empirical and theoretical research on business inventories is surveyed and critically evaluated. While most inventory research has had macroeconomic motivations, we focus on its microtheoretic basis and on potential conflicts between theory and evidence. The paper asks two principal questions. First, how can inventories, which are allegedly used by firms to stabilize production, nonetheless be a destabilizing factor at the macroeconomic level? Second, why, if firms are following the production-smoothing model, is production more variable than sales in many industries? We suggest that the so-called (S, s) model may help answer both questions.

This paper builds and estimates a new model of rm behavior that includes decisions to order, use, and stock input materials in a stage-of-fabrication environment with either gross production or value added technology. The model extends the traditional linear-quadratic model of output nished goods inventories by incorporating delivery and usage of input materials plus input inventory investment features which largely have been ignored in the literature. Stylized facts indicate that input inventories are empirically more important than output inventories, especially in business cycle uctuations. Firms simultaneously choose input and output inventories; thus, the model exhibits feedback b e t ween stocks induced by dynamic stage-of-fabrication linkages. Estimation of inventory decision rules shows the model is reasonably consistent with data in nondurable and durable goods industries. The results reveal inventory stock i n teraction, convex costs, viability o f gross production and value added speci cations, industrial di erences, and input inventory-saving technology. JEL Classi cation: E22, E23

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A formal model of our explanation yields a previously untested implication that is supported by the data.