Why Do Real and Nominal. Inventory-Sales Ratios Have Different Trends?

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1 Why Do Real and Nominal Invenory-Sales Raios Have Differen Trends? By Valerie A. Ramey Professor of Economics Deparmen of Economics Universiy of California, San Diego and Research Associae Naional Bureau of Economic Research and Daniel J. Vine Economis Division of Research and Saisics Board of Governors of he Federal Reserve Sysem We have benefied from helpful discussions wih Chad Jones and Charles Seindel. Valerie Ramey graefully acknowledges suppor from he Naional Science Foundaion Gran # Opinions expressed here are hose of he auhors and no hose of he Board of Governors of he Federal Reserve Sysem.

2 Business and academic economiss closely wach he invenory-sales raio as a poren of fuure producion, a remnan of pas misakes, and a measure of supply chain efficiency. Specifically, he downward rend in he US invenory-sales raio is ofen offered as evidence ha informaion echnology is fundamenally changing he US economy. For example, Federal Express presens he following quoe from SRI Inernaional on is web page: The impac of he Supply Chain Revoluion on firms abiliy o rim excess invenories is manifesed in he seady, downward rend in U.S. invenory-o-sales raio over he pas wo decades. The evidence is no so clear, however. The invenory-sales raio consiss of a sock variable divided by a flow variable, which means ha i is measured in unis of ime, such as he number of days of sales held in invenory. Time should no depend on wheher sales and invenories are boh measured in real or nominal dollars. Ye as poined ou by Ramey and Wes in he 1999 Handbook of Macroeconomics chaper on invenories, he rends in real and nominal aggregae invenory o final sales raios are very differen. Consider he behavior of he invenory-sales raios shown in Figure 1. 1 While he raio of curren dollar (nominal) nonfarm invenories o final sales shows a significan downward rend saring in he early 1980s, he 1996 chained dollar (real) raio shows no such rend. According o he real raio, he aggregae invenory-sales raio was no lower in 2003 han i was in Mos business discussions of he invenory-sales raio use curren dollar numbers from he Naional Income and Produc Accouns (NIPA) or from he Census M3 repors for manufacuring and rade. Mos invenory research in economics, on he oher hand, uses real chained-dollar daa from he Bureau of Economic Analysis (BEA). 1 Daa for Figures 1 and 2 were obained from he NIPA accouns in November

3 [Figure 1 here.] Despie he very differen picures presened by hese wo series, here has been lile discussion of he source of he differences or of which measure mos accuraely reflecs he hisorical rend in US invenories. Undersanding why he nominal and real raios have such differen rends is imporan for resolving a number of conroversies involving he role of invenories in he business cycle in recen decades. I is widely believed ha he informaion echnology (IT) revoluion has led o a subsanial decline in invenory-sales raios. Moreover, he changing behavior of invenories is also a prime suspec in he decline in GDP volailiy since 1984 (Kahn, McConnell, Perez-Quiros 2002). Thus, several key heories and explanaions depend crucially on he behavior of he invenory-sales raio. This noe offers an explanaion for he difference beween nominal and real aggregae invenory-sales raio rends. Simply saed, he aggregae invenory-sales raio includes services in he denominaor, bu no in he numeraor, since services canno be sored. Alhough he real share of sales ha come from indusries ha hold invenories has changed over ime, is behavior is no he source of he difference in rends beween he real and nominal invenory-sales raio in U.S. daa. Raher, i is he srong secular decrease in he relaive price of goods and srucures ha is a he hear of he discrepancy. A firs glance, one migh suspec ha using chained-dollar price deflaors is problemaic. As he BEA poins ou, chain-weighed daa should no be aggregaed by simple addiion. Chain-weighed daa have he advanage, however, of giving he mos accurae depicion of growh of real quaniies over ime. Since he invenory-sales raio is a raio of wo quaniies 2

4 raher han a sum, chain-weighed daa do give an accurae represenaion of he growh rends in he invenory-sales raio, hough perhaps no of he level a any poin in ime. A few simple equaions and graphs make he argumen clear. Le H denoe he real level of invenories, S denoe he real level of final sales, and P denoe he price level. The subscrip g sands for goods plus srucures and he subscrip v sands for services. The real invenory sales raio is given by: Real invenory-sales raio = H S H g =. S The numeraor includes only invenories of goods and srucures, while he denominaor includes final sales of goods, srucures and services. In he daa, he denominaor is he chained dollar value of final sales in year. Is growh is relaed o he growh raes of secoral sales according o he following formula: 2 S PS g g + PS v v Pg 1Sg + Pv 1Sv = S 1 PS g g 1+ PS v v 1 Pg 1Sg 1+ Pv 1Sv 1 The real dollar value of sales is compued by applying his formula o nominal sales in a base year (1996 for our daa), and exending he series backward and forward. In conras, he nominal invenory sales raio can be wrien as: Nominal invenory-sales raio = P H P H = P S P S g g g g. Thus, he nominal invenory-sales raio is equal o he real invenory-sales raio muliplied by he price of goods and srucures relaive o goods, srucures and services, (P g /P). The BEA also publishes invenory-sales raios ha use final sales of only goods and srucures in he denominaor. Figure 2 shows he behavior of he real and nominal versions of 2 See Whelan (2000) for a useful discussion of chain-weighed daa. 3

5 his raio. There is lile difference beween hese raios because he price deflaors for he numeraor and denominaor are he same. The paerns in boh invenory-sales raios show a general increase unil 1980 and hen a decline ha begins in he 1980s and coninues hrough he 1990s so ha hey now sand a heir levels in he 1950s. [Figure 2 abou here] Consider nex he relaive price of goods and srucures o all final sales, P g /P, which affecs only he broader nominal invenory-sales raio. Figure 3 displays he hisory of his raio in US quarerly daa. 3 The relaive price of goods and srucures decreased by 37 percen since Moreover, i decreased a a faser rae in he pos-1980 period, he same ime ha he real and nominal invenory-sales raios show he larges discrepancies. [Figure 3 here] Thus, he culpri behind he aggregae real and nominal invenory-sales raio rend discrepancies is eviden. The price of goods and srucures has decreased relaive o services in he pos-wwii period. This decrease causes he nominal invenory-sales raio o diverge from he real invenory-sales raio because services appear only in he denominaor. Which invenory-sales raio should one use, real or nominal? While he level of he invenory-sales raio a any paricular poin in ime is bes measured in curren dollars (so he 3 The price deflaors are consruced by dividing curren dollar final sales by chained dollar final sales. For he goods plus srucures aggregae, we consruced chained-dollar daa using a version of he chain-weighing formula shown earlier in which he wo sub-secors were goods and srucures. 4

6 relaive prices are correc), comparisons of he invenory-sales raio beween differen poins in hisory, including he measuremen of growh rends, is bes done wih he chained-dollar invenory-sales raio. The rend in he nominal raio is impaced by relaive price changes, and hence can be very misleading. For many purposes, such as sudying he hisorical effecs of informaion echnology on invenory holdings or he connecion beween invenory-sales rends and business cycle volailiy, he chain-weighed raio is he correc raio o use. On he oher hand, he nominal raio may be more appropriae for some sudies of credi and working capial requiremens for financing he dollar value of invenories. For sudies of invenory-sales raios of more homogenous goods, such as for manufacured goods, boh nominal and real raios should presen similar picures since changes in relaive prices are no an issue. Oher aggregaion issues migh come ino play, hough. As discussed by Irvine (2003), shifs in he share of sales across secors wih differen invenory-sales raios can lead he aggregae invenory-sales raio o behave differenly from he disaggregaed raios. 5

7 LITERATURE CITED Irvine, F. Owen. (2003) Long Term Trends in US Invenory o Sales Raios. Inernaional Journal of Producion Economics, 81-82, Kahn, James A., Margare M. McConnell and Gabriel Perez-Quiros. (2002) On he Causes of he Increased Sabiliy of he U.S. Economy. FRBNY Economic Policy Review, 8:1, Ramey, Valerie A. and Kenneh D. Wes. (1999) Invenories. In Handbook of Macroeconomics, edied by John D. Taylor and Michael Woodford, pp Amserdam: Elsevier Science Press. Whelan, Karl. (2000) A Guide o he Use of Chain Aggregae NIPA Daa Federal Reserve Board of Governors Finance and Economics Discussion Series,

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