The Power of Demand: A General Equilibrium Analysis of Multi-Stage-Fabrication Economy with Inventories

Due to lack of models that can feature both output- and input-inventories simultaneously, several well known puzzles pertaining to inventory fluctuations and the business cycle have not been well explained by dynamic optimization theory. By presenting a general equilibrium, multi-stage production model of inventories with separate decisions to order, use, and stock input materials and to produce, sell, and store finished output, this paper offers not only a model of input-output inventories but also a neoclassical perspective on the theory of aggregate demand. It shows that due to production/ delivery lags, firms opt to hold both output- and input-inventories so as to guard against demand uncertainty at all stages of production. As a result, not only is production more volatile than sales but also is inputordering more volatile than input-usages, giving rise to a chain-multiplier mechanism that propagates and amplifies demand shocks at downstream towards upstream via input-output linkages. This multiplier effect induced by precautionary inventory investment at each production stage can explain several long-standing puzzles of the business cycle documented in the inventory literature.