Rational expectations and the smoothing properties of inventories of finished goods

This paper formulates and estimates a dynamic rational expectations equilibrium model of inventories of finished goods and employment of labor. The view that the primary role of inventories of finished goods is to act as a buffer stock in the face of fluctuating demand is examined. Both the model and estimation results indicate that this is the case because of differences in the costs involved for firms in changing their inventory stocks and labor force. In addition to providing some new evidence on the behavior of inventories of finished goods and employment, the paper illustrates a technology for maximum-likelihood estimation of structural parameters under the hypothesis of rational expectations.