This is the first of a series of posts that I’ll call “An Introduction to Economics.” Their goal will be to explain an economic term that is unfamiliar to many people but frequently occurs (and frequently inaccurately) in news reports or other items that visitors of this site may come across. This first Econ 101 post explains how changes in private inventories are accounted for in the National Income and Product (GDP) accounts, where the proportion of rising or declining inventories to GDP growth is frequently disputed.
The government’s most recent publication of GDP figures for the third quarter of 2011 was on December 22. Growth in overall GDP was estimated (and disappointing) at 1.8 percent. However, according to several news reports, private stockpiles declined, and that if these stocks had not altered, GDP growth would have been 1.4 percentage points higher, or 3.2 percent. However, by looking at the BEA’s (Bureau of Economic Analysis, US Department of Commerce) underlying GDP numbers, one can find that the change in private inventories was basically zero (and in fact was slightly positive). Why did many analysts claim that a drop in inventories impacted GDP growth in the quarter if inventories did not fall?
While the GDP (Gross Domestic Product) accounts track the flow of production (how much was produced over a given period of time) and the flow of how much was then sold (for consumption or investment), inventories are a stock, and the change in the stock of inventories is what is recorded in the GDP accounts.
GDP is the flow of commodities and services created in the economy, which are then sold for a variety of uses, including private consumption, private fixed investment, government consumption and investment, and exports, with imports also serving as a source of items for sale.
However, products produced during one period may not necessarily correspond to goods sold during that same period.
The discrepancy is explained by either an increase or decrease in inventories.
As a result, when the change in inventory is added to final sales (with imports as a negative), the total goods and services produced equals GDP.
We are usually interested in how much GDP increased or decreased from one period to the next in comparison to the prior one.
And we’re curious to discover how much of that GDP increase corresponds to and can be explained by growth in consumption, investment, and other aspects of final sales.
These demand components are critical, especially in the current economic climate.
With significant unemployment and output substantially below capacity, demand drives the production of products and services.
As a result, the shift in consumption, fixed investment, or government expenditures from one era to the next is being studied.
And, as the balance item between GDP output and final sales, the change in stocks would now be examined.
The phrase “The phrase “change in inventory” is a mouthful, and it’s not something you’ll read in the news very often (indeed, I have never seen it used).
But this is precisely what causes the consternation.
As indicated above, the change in private inventories was nearly nil in the third quarter of 2011 (according to BEA estimates released on December 22).
However, private inventories increased in the second quarter of 2011, which was a positive sign. As a result, the change in inventory, which went from positive to nearly zero, was negative. That is, if inventories had continued to rise at the same rate as in the second quarter, GDP growth would have been 3.2 percent rather than 1.8 percent in the third quarter of 2011. Because of the change in inventories, GDP growth was 1.4 percentage points lower than it would have been otherwise.
Simple numerical examples are likely the easiest way to demonstrate the topic.
Assume that GDP (the production of goods and services) is originally 1000 (in billions of dollars), and that total final sales (for consumption, fixed investment, and so on) is 950 for some imaginary economy.
With 1000 units produced and 950 units sold, inventories will rise by 50 percent.
Assume the inventory stock at the start of the period is 500, and the stock at the conclusion of the period is 550 (50 more).
The following are the figures:
Do inventories boost the economy?
As we all know, Gross Domestic Product (GDP) is the most important indicator of global economic activity. This result is made up of a number of variables that push and pull it depending on the macroeconomic backdrop’s mechanics. Inventories, in particular, are a component of GDP that we should refresh our memories on. The change in private inventories was the second most significant contributor to GDP growth during the first quarter, according to the most recent GDP data from the Bureau of Economic Analysis (BEA), but what are the dynamics behind this fact?
To begin, it’s important to remember that GDP is a measure of economic productivity that takes into account the consumption of various economic sectors. Consumer spending C, investment I, government expenditure G, and net exports NX are all components of GDP. Of course, we must emphasize that the GDP only considers domestic activity, thus items that are imported are omitted from the calculation, while items that are exported are included. As a result, exports minus imports equals NX.
These areas are bolded and split in the BEA report, with each category broken down further. However, because the focus here is on inventory, I elected to overlook G and NX for the purposes of this discussion. So, what role do inventories play? The explanation is that inventory levels are not included in GDP; yet, changes in inventory have an impact on GDP since they affect investments (Capital expenditures are also part of invesments, but for simplicity I ignore these effects). So, if a company decides to increase its inventory by D,
What is the relationship between inventories and GDP?
The investment in inventory is a part of the gross domestic product (GDP). What is created in a country is, of course, eventually sold, but some of the commodities produced in one year may be sold in a subsequent year rather than the year in which they were produced. On the other hand, some of the commodities sold in a given year may have been manufactured in a previous year. Inventory investment is the difference between items produced (production) and goods sold (sales) in a particular year. The notion can be applied to the entire economy or to a single company, but it is most commonly used in macroeconomics (economy as a whole). Unintentional unsold inventory raises inventory investment.
In economics, what is inventory change?
The difference between additions to and withdrawals from inventories is characterized as changes in inventories (or stocks). Changes in the following items are included in national accounts:
- stocks of outputs retained by the units that created them before being processed, sold, transported to other units, or utilised in other ways;
- Stocks of products bought from other units that will be utilized for intermediate consumption or resale without additional processing in the future;
- Work-in-progress goods are those that are being processed but have not yet been delivered to the customer at the conclusion of the accounting period.
- Government agencies are in charge of strategic stockpiles (food, oil, stocks for market intervention).
Changes in inventories are reflected in the national accounts as a change in assets in the capital account.
When inventories rise, what can we expect?
We can anticipate aggregate production to be unaffected if corporate inventories rise unintentionally. We can anticipate an increase in production from enterprises. We can anticipate enterprises to reduce output levels.
Key Points
- GDP = consumption + investment + government expenditure + exports imports, according to the expenditures method.
- The output method is also referred to as the “net product” or “value added” method.
Key Terms
- Total spending on all final goods and services (Consumption goods and services (C) + Gross Investments (I) + Government Purchases (G) + (Exports (X) Imports (M)) is the expenditure approach. GDP = C + I + G + I + I + I + I + I + I + I + I (X-M).
- GDP is estimated using the income approach by adding up the factor incomes and the factors of production in the community.
- GDP is estimated using the output approach, which involves summing the value of items sold and correcting (subtracting) for the cost of intermediary goods used to make the commodities sold.
In a balance sheet, what are inventories?
The term inventory refers to both the raw materials utilized in production and the finished goods that are ready to sell. Inventory is one of a company’s most valuable assets because inventory turnover is one of the key sources of revenue production and, as a result, earnings for the company’s shareholders. Raw materials, work-in-progress, and finished goods are the three forms of inventory. On a company’s balance sheet, it’s classified as a current asset.
What effect do net exports have on GDP?
When a country exports things, it is selling them to a foreign market, such as consumers, enterprises, or governments. These exports bring money into the country, increasing the GDP of the exporting country. When a country imports items, it does so from overseas manufacturers. The money spent on imports leaves the economy, lowering the GDP of the importing country.
Negative or positive net exports are possible. Net exports are positive when exports outnumber imports. Net exports are negative when exports are less than imports. If a country exports $100 billion worth of goods and imports $80 billion, it has $20 billion in net exports. This sum is added to the GDP of the country. If a country exports $80 billion in goods and imports $100 billion, it has negative net exports of $20 billion, which is deducted from GDP.
Net exports might theoretically be zero, with exports equaling imports, and this does happen in the United States on occasion.
A country’s trade balance is positive if net exports are positive. If they’re negative, the country’s trade balance is negative. Almost every country in the world desires a larger economy rather than a smaller one. That is to say, no country wishes to have a negative trade balance.
What impact does inventory have on economic activity?
More inventories contribute to more volatile sales and increases in GDP variability when the first effect dominates. When the second effect is dominant, however, bigger inventories actually reduce the volatility of sales and, as a result, GDP.