It is widely believed in the literature that inventory fluctuations are destabilizing to the economy. This paper re-assesses this view by developing 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. However, contrary to common beliefs, the model predicts that inventories are stabilizing, rather than destabilizing. The volatility of aggregate output could rise by 30% if inventories were eliminated from the economy. 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 final goods), 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.
