This Economics Research Note examines inventories in the business cycle for Australia covering the period since the mid 1980s. The Australian Bureau of Statistics (ABS) defines inventories as all materials etc., work in progress and finished goods owned by a business, whether held at locations of the business or elsewhere. These items are usually held by businesses in anticipation of a product’s sale. Inventory investment is counted as an additional contribution to gross domestic product (GDP).Inventories; Business cycles

Chindamo, Phillip

English

Research Papers in Economics

 
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Inventories in the Australian business cycle 
Introduction 
This Economics Research Note examines inventories in the business cycle for Australia covering the 
period  since  the mid  1980s.    The  Australian Bureau  of  Statistics  (ABS) defines inventories  as  all 
materials etc., work in progress and finished goods owned by a business, whether held at locations of 
the business or elsewhere.  These items are usually held by businesses in anticipation of a product’s 
sale.  Inventory investment is counted as an additional contribution to gross domestic product (GDP). 
This Note finds evidence of an inventory cycle at both the aggregate economy level and also for the 
manufacturing industry.  Fluctuations in inventories have played a significant role in amplifying and 
exacerbating the business cycle and continue to significantly detract from GDP growth during periods 
of economic downturn. 
Rationale for holding inventories 
Why do businesses hold and accumulate inventories when there are costs associated with doing so – 
such as depreciation and storage costs?  Inventories are held by businesses for a number of reasons: 
· · · ·  In anticipation of future demand by customers when additional demand cannot be immediately 
met by increased production. 
· · · ·  As a means of reducing the impact of demand uncertainty. 
· · · ·  The reduced cost of having to order goods less frequently. 
· · · ·  As  a  tool  to  smooth  production  –  rather  than  constantly  change  the  level  of  production, 
inventories can be used to deal with fluctuating demand. 
· · · ·  As an unavoidable consequence of production and supply variance. 
Businesses may also have a desired inventory to total sales ratio which fluctuates with the business 
cycle.  For example, in the situation of high demand may mean that a business would prefer a higher 
inventory to sales ratio to meet ongoing high demand. 
The aggregate inventory cycle  
The  inventory  cycle  relates  to,  and  occurs  because  of,  the  distinction  between  planned  and 
unplanned  inventory  accumulation.    When  sales  are  unexpectedly  low,  unplanned  inventories  
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accumulate.    In  comparison,  some  businesses  may  plan  for,  and  implement,  an  inventory 
replenishment program whereby inventory investment is high in order to restore a desired inventory 
to sales ratio.  In this case businesses are purposely adding to their inventories. 
Chart 1 shows the levels of inventories for Australia and the ratio of inventories to sales.  While the 
level  of  inventories  has  risen  steadily  since  the  mid  1980s,  the  growth  of  sales  has  been  even 
stronger so that the inventories to sales ratio for the economy has declined to approximately 0.68 in 
2010, suggesting that on average businesses hold approximately 8 months worth of their annual 
sales as inventories. 
Chart 1: Inventories and inventories to sales ratio
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Inventories Inventories-sales ratio (RHS)
 
(a) Source: ABS. Non-farm, chain volume measures, seasonally adjusted.  
Inventory  levels  tend  to  fluctuate  much  due  to  the  fact  that  some  inventories  accumulation  is 
unplanned  by businesses  (the  so  called  inventory cycle)  and  this  in  turn  can  contribute  to,  and 
explain, the business cycle (the volatility of GDP around a long-term trend).  That is, when demand 
falls  in  a  contractionary  period,  businesses  may  have  unplanned  inventory  accumulation.    The 
response may be to address this unwanted accumulation by cutting production and inventories in 
the face of reduced or flat sales.  In doing so this may amplify the degree of contraction in the 
economy than would be the case if inventories had not been accumulated in an unplanned way. 
Chart 2 shows the periods where there has been an economic downturn in Australia (approximated 
by periods of one or more quarters of negative GDP(P) growth) together with inventories, sales and 
the ratio of inventories to sales.   
In the period around March 1986 when there was a negative GDP growth episode, we can see from 
Chart 2  that  sales  began  declining  ahead  of  the  economic  downturn,  resulting  in  significant 
unplanned inventory accumulation in the first quarter of 1986 and hence a rising inventories to sales  
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ratio.  As a consequence, businesses reacted by reducing production and inventories from the second 
quarter of 1986 at a time when sales were still falling, hence amplifying the downturn.  Inventories 
continued to decline beyond the period of negative GDP growth even after sales began to grow and 
hence the inventories to sales ratio declined below the ratio level prior to the economic downturn.   
When  we  examine  the  recessionary  period  of  the  early  1990s,  Chart  2  shows  that  again,  the 
inventory cycle contributed to an exacerbated economic downturn.  We see the unwanted build up 
of inventories in the lead up to the recession at a time when sales had begun to decline.  Sales 
continued to decline into the recessionary period and the level of inventories decline commenced 
approximately half way during the recessionary period.  The inventories to sales ratio climbed in the 
first half of the recessionary period and then declined.   
In relation to the recent negative GDP growth period associated with the global financial crisis (GFC), 
there was a clear build up in inventories in the lead up, with businesses only beginning to shed 
inventories just preceding this period.  However, the decline in inventories was marginally earlier and 
less pronounced than the decline in sales that resulted from the collapse of demand during the GFC. 
Hence  the  inventory  to  sales  ratio  increased  over  this  period.    Since  early  2009  the  level  of 
inventories has stabilised and with a strong resumption in sales, the resulting inventory to sales ratio 
has declined again.   
Chart 2: Inventories, sales and inventories to sales ratio
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Inventories Sales Inventories-sales ratio (RHS)
 
(a) Source: ABS. Non-farm, chain volume measures, seasonally adjusted. 
Chart 3 compares the percentage point contribution of the change in inventories to GDP growth over 
the three economic downturn episodes outlined in Chart 2.  Period t represents the quarter in which 
there was a trough in the quarterly GDP growth rate and the other periods represent the 3 quarters 
before and after this point.    
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In the period around March 1986, we can see from Chart 3 that inventories were making a positive 
contribution  up  until  the  quarter  representing  the  trough  in  GDP  growth  and  in  this  quarter 
inventories  reduced  the  quarterly  GDP  growth  rate  by  a  significant  1.3  percentage  points.    This 
significant  negative  contribution  to  GDP  growth  continued  beyond  the  period  representing  the 
trough in growth (hence exacerbating the economic downturn), with inventories taking a further 
1.2 percentage points off GDP growth in the following quarter, before making a positive contribution 
in the second quarter after the trough. 
During  the  economic  downturn  period  in  the  early  1990s,  Chart  3  shows  that  the  change  in 
inventories had a benign impact on the GDP growth rate in the period preceding and during the 
trough  in  GDP  growth,  with  the  negative  contribution  to  GDP  growth  from  inventory  declines 
occurring in the quarter after the trough in GDP growth.  
During the recent negative GDP growth period during 2008-09, in contrast to the previous economic 
downturn episodes, the negative contribution of a change in inventories to GDP growth occurred 
mainly preceding the trough in GDP growth.  Chart 3 shows that in the quarter preceding the trough, 
the change in inventories reduced GDP growth by 1.4 percentage points, which is the most significant 
one-quarter negative impact in any of the three episodes examined.  A quarter after the trough in 
GDP growth, the decline in inventories was still taking away 0.5 percentage points from GDP growth. 
Chart 3: Percentage point contribution of inventories to growth during economic downturns 
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Volatility over the business cycle 
Having examined inventories, sales and the ratio of inventories to sales over the past 25 years, it is 
worth considering whether the volatility of inventories over the business cycle has changed.  To do  
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this, inventories and GDP are ‘decomposed’ so that the cyclical component of each is identified.
1  
Chart 4 presents these estimated cyclical components of GDP and inventories.  
Chart 4: Cyclical components of GDP and inventories 
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Cyclical GDP Cyclical inventories
 
Chart 4 shows that inventories are procyclical (a statistically significant correlation coefficient of 0.43 
with respect to the cyclical component of GDP).  The cyclical component of inventories has been 
more volatile than the cyclical component of GDP (respective standard deviations of 0.02 and 0.01).  
Moreover, while the volatility of both the cyclical components of GDP and inventories have declined 
overtime, the decline in the volatility of inventories has been less pronounced, suggesting that while 
there may be offsetting components of GDP that have lead to a moderation in GDP volatility, the 
inventory cycle continues to play a role in contributing to (smaller) fluctuations in GDP. 
The inventory cycle for the manufacturing industry 
The manufacturing industry is a significant holder and accumulator of inventories in the Australian 
economy, holding an average of 40 per cent of total non-farm inventories in Australia since the mid 
1980s.  Therefore it is expected that the inventory cycle at the industry level may play a role in the 
growth performance of the manufacturing industry itself and the economy as a whole. 
Chart 5 presents the periods where there has been an economic downturn in Australia together with 
inventories, sales and the ratio of inventories to sales for the manufacturing industry.  The inventory 
to sales ratio for the manufacturing industry has declined over this entire period more rapidly than 
for the economy as a whole and is approximately 0.50 in 2010, suggesting manufacturing businesses 
                                                 
1 In technical terms, a Hodrick-Prescott filter is applied to identify the cyclical component of each variable.  The cyclical components are represented as 
natural log deviations from trend to enable comparison.  
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hold approximately 6 months worth of their annual sales as inventories.  Examining the three periods 
of economic downturn identified: 
· · · ·  The inventory cycle is clear for the period of early 1986.  The level of inventories in late 1985 
was rising fast in the manufacturing industry.  The level peaked in the quarter preceding the 
trough in GDP growth and then proceeded to decline at the same rate in the 3 quarters after 
the trough (essentially an inverted V shaped response).  Sales essentially continued to grow 
through this period so the inventories to sales ratio peaked during the same quarter as the 
trough in GDP growth and then declined linearly after that point (and continued to decline in 
the 3 years that followed). 
· · · ·  The economic downturn of the early 1990s involved a similar inventory cycle experience for the 
manufacturing industry.  There was an increase in inventory levels (reversing the trend in the 
three preceding years) in early 1990 around the same time that sales dipped considerably.  This 
resulted in unwanted inventory accumulation and a rapidly declining inventory to sales ratio 
from the midpoint of the recessionary period (as sales began picking up). 
· · · ·  The recent economic downturn period was associated with a preceding fall in demand for 
manufactured goods as sales declined from June 2008 and continued to fall.  Since inventories 
were falling over the same time but at a slower pace, the inventories to sales ratio rose over 
this period with a subsequent downward adjustment in the ratio after the identified economic 
downturn period. 
Chart 5: Inventories, sales and inventories to sales ratio for manufacturing
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40,000
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Sep-85 Sep-88 Sep-91 Sep-94 Sep-97 Sep-00 Sep-03 Sep-06 Sep-09
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Inventories Sales Inventories-sales ratio (RHS)
 
(a) Source: ABS. Chain volume measures, seasonally adjusted.  
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Conclusion 
The inventory cycle occurs because of planned and unplanned inventory accumulation.  In comparing 
the behaviour of inventories, sales and the inventories to sales ratio since 1985 and specifically over 
three  identified  episodes  of  economic  downturn,  there  is  evidence  of  an  inventory  cycle  at  the 
aggregate  level  and  for  the  manufacturing  industry.    Even  though  businesses  have  increasingly 
implemented  just-in-time  production  processes  so  as  to  minimise  the  need  to  hold  unwanted 
inventories, fluctuations in inventories continue to exacerbate the business cycle and significantly 
detract from GDP growth during periods of economic downturn.  Changes in inventories exacerbated 
the downward movement in GDP during the early period of 1986, in the recessionary period of the 
early 1990s and most recently in 2008-09.  The cyclical component of inventories is much more 
volatile than the cyclical component of GDP and while this volatility has generally declined for both 
GDP and inventories, the volatility of inventories remains much more pronounced, suggesting that 
the inventory cycle continues to play a role in the business cycle. 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Contact  
Phillip Chindamo, Chief Economist, Ai Group Economics and Research Unit, http://www.aigroup.com.au/economics. 

Inventories in the Australian business cycle

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