Question

Businesses hold inventories of goods, partly as finished products and partly as goods-in-process and raw materials. Suppose that we think of inventories as a type of capital, which enters into the production function. Then changes in these stocks represent investment in inventories. (Typically, economists assume that the rate of depreciation on inventories is near zero.)

1. How does an increase in the real interest rate affect the quantity of inventories that businesses want to hold? What happens, therefore, to inventory investment?

2. Consider temporary adverse shock to the production function. What happens to the amount of inventory investment?

Answer 1

The core reason for producers to have a high inventory or goods which are still in production is that they expect a steady demand in the market place. Usually, demand is a straight up determined by the interest rates that are there in the country. A lower interest rate allows for demand to take place at a relatively lesser cost whereas an increased interest rate means that consumers have to bear additional interest if they purchase the products on credit.

As bank loans become cheaper, it is thus easier for consumers to consume more goods and services, whereas as they increase, it becomes all the more difficult for them to purchase goods.

It is this very anticipation of demand, which makes companies hold inventories or not. Thus, as real interest rates increase, the incentive to hold inventory is less as the demand for goods and services during this critical period may remain extremely low. The exact opposite happens, when the interest rate decreases.

Similarly. when there is an adverse shock to the production function, the productivity of the staff either decreases or increases. If it increases, i.e. the per unit cost of production decreases, the incentive to hold additional inventory also increases. Similarly, if there is a negative shock meaning, that the cost of production increases and so does the per unit cost, the incentive to hold additional inventory is negative and the firms would not prefer to do the same.

Thus, we can conclude by saying, that companies maintain inventory to either enable themselves to use if there is additional or stable demand for goods and services expected. They would want to clear the inventory as soon as possible in case cost of production is increasing or if they expect the demand to go down.

Please feel free to ask your doubts in the comments section if any.