Inventory Mistakes and the Great Moderation

Why did the volatility of U.S. real GDP decline by more than the volatility of final sales with the Great Moderation in the mid-1980s? One possible explanation is that firms shifted their inventory behaviour towards a greater emphasis on production smoothing. In this paper, we investigate the role of inventories in the Great Moderation by estimating an unobserved components model that identifies inventory and sales shocks and their propagation. We find only mixed evidence of increased production smoothing. Instead, it was a reduction in inventory mistakes that accounts for the excess volatility reduction in output relative to sales. The inventory mistakes are informational errors related to production that must be set in advance and their reduction also helps to explain the changed forecasting role of inventories since the mid-1980s. Our findings provide an optimistic prognosis for the continuation of the Great Moderation.