Manufacturers' raw materials inventory investment and the cost of capital

An understanding of business inventory movements is crucial to an understanding of macroeconomic fluctuations. Although inventory investment is a relatively small component of GNP (less than 2% on average), it has accounted for a large share of output declines during economic downturns. This dissertation is an empirical study of the behavior of manufacturers' raw materials investment, with a particular focus on whether short-term real interest rate movements have a significant effect on target holdings of raw materials. The thesis begins with a review of the current empirical literature on inventories and an investigation of the stylized facts about the time series behavior of raw materials inventories. It then formulates a rational expectation model of a representative firm's decision to purchase and hold raw materials stocks. A purchasing agent minimizes the sum of expected future purchasing and inventory holding costs. Costs are represented as linear and quadratic functions of inventories, deliveries, and inputs. Stochastic interest rates enter the model in a way which is consistent with recent literature on inventories and interest rates. Application of Bellman's method of dynamic programming yields a linear Euler condition, a structural equation relating inventory holdings to production requirements, current and one-period-ahead prices of raw materials, inherited inventory stocks, and the cost of capital. The model is estimated for nineteen manufacturing industries on data disaggregated to the two-digit SIC level. Parameter estimation is by an instrumental variables technique, and the estimated covariance matrix is corrected for heteroskedasticity and the MA(1) structure implied by the informational structure of the model. The results are largely negative, corroborating the stylized facts reported in the dissertation and extending the negative findings in the empirical literature on manufacturers' inventories and interest rates to raw materials inventories.