This paper develops an analytically-tractable general-equilibrium model of inventory dynamics based on a precautionary stockout-avoidance motive. The model’s predictions are broadly consistent with the U.S. business cycle and key features of inventory behavior, including (i) a large inventory stock-to-sales ratio and a small inventory investment-to-sales ratio in the long run, (ii) excess volatility of production relative to sales, (iii) procyclical inventory investment but countercyclical stock-to-sales ratio over the business cycle, and (iv) more volatile input inventories than output inventories. It is also shown that technological improvement of inventory management (that eliminates production/ordering lags) can increase, rather than decrease, the volatility of aggregate output. Key to this seemingly counter-intuitive result is that a stockout- avoidance motive leads to procyclical liquidity-value of inventories (hence, procyclical relative prices of output), which acts as an automatic stabilizer that discourages final sales in a boom and encourages final sales during a recession, thereby reducing the variability of GDP.
