Inventories and Optimal Monetary Policy

CAMA Working Paper No. 7/2010

33 Pages Posted: 31 Aug 2010

See all articles by Thomas A. Lubik

Thomas A. Lubik

Johns Hopkins University - Department of Economics

Wing Leong Teo

National Taiwan University - Department of Economics

Date Written: October 1, 2009

Abstract

We introduce inventories into a standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model to study the effect on the design of optimal monetary policy. The possibility of inventory investment changes the transmission mechanism in the model by decoupling production from final consumption. This allows for a higher degree of consumption smoothing since firms can add excess production to their inventory holdings. We consider both Ramsey optimal monetary policy and a monetary policy that maximizes consumer welfare over a set of simple interest rate feedback rules. We find that in contrast to a model without inventories, Ramsey-optimal monetary policy in a model with inventories deviates from complete inflation stabilization. In the standard model, nominal price rigidity is a deadweight loss on the economy, which an optimizing policymaker attempts to remove. With inventories, a planner can reduce consumption volatility and raise welfare by accumulating inventories and letting prices change as an equilibrating mechanism. We find also find that the application of simple rules comes very close to replicating Ramsey optimal outcomes.

Keywords: Ramsey policy, New Keynesian model

JEL Classification: E24, E32, J64

Suggested Citation

Lubik, Thomas A. and Teo, Wing Leong, Inventories and Optimal Monetary Policy (October 1, 2009). CAMA Working Paper No. 7/2010. Available at SSRN: https://ssrn.com/abstract=1668128 or http://dx.doi.org/10.2139/ssrn.1668128

Thomas A. Lubik (Contact Author)

Johns Hopkins University - Department of Economics ( email )

3400 Charles Street
Baltimore, MD 21218-2685
United States

Wing Leong Teo

National Taiwan University - Department of Economics ( email )

21 Hsu Chow Road
Taipei, 10020
Taiwan

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