Inventory changes play an important role, mainly serving as a signaling device that alerts producers to changes in aggregate demand. They also play two other important roles in macroeconomics.

First, desired inventory changes are a component of aggregate demand that affects the dynamics of an economy’s reaction to disequilibrium, thereby playing an important role in the propagation and maintenance of business cycles. Consider a stimulating dose of fiscal policy. As the economy goes through the multiplier process, inventories are constantly falling because aggregate demand is continually a bit higher than output. If firms do nothing about these reductions, after the multiplier process has worked itself out inventories will have fallen to an undesirably low level. To prevent this result, firms must produce some extra output during the multiplier process. The time path followed by the economy during the multiplier process is affected by when and how quickly the firm decides to do so. If, for example, the firm elects to increase output to restore inventory levels at a late stage in the multiplier process, the level of national income could temporarily overshoot its final level.

Second, inventory changes can help in forecasting the direction of the economy. Their use in this regard occurs frequently in newspaper commentary, where they play a more prominent role than complex economic models built expressly for forecasting purposes.

When inventory levels are unusually high or are rising rapidly, firms should react by cutting back on production—meeting demand out of inventory—to decrease inventory levels to a more desirable level. This production cutback decreases income, however, setting the multiplier process in motion and pushing the economy toward a recession. We should forecast a downturn in the economy.

When inventory levels are unusually low or are falling rapidly, firms should react by increasing production to build inventories up to a more desirable level. The production increase also increases income, however, setting the multiplier process in motion and thereby pushing the economy to an even higher level of income. We should forecast an upturn in the economy.