Inventory Investment and the Real Interest Rate

The relationship between inventory investment and the real interest rate has been difficult to assess empirically. Recent work has proposed a linear-quadratic inventory model with time-varying discount factor to identify the effects of the real interest rate on inventory investment. The authors show that this framework does not separately identify the effects of real interest rate on inventory investment from variables that determine the expected marginal cost of production. In other words, the model does not deliver a testable restriction on the impact of interest rates on inventory investment. The authors highlight the consequences for both short-and long-run empirical analyses. They conclude that understanding the relationship between inventory investment and the real interest rate continues to be a theoretical and empirical challenge for macroeconomists.