We develop a general-equilibrium model of inventories with explicit micro-foundations by embedding the production-cost-smoothing motive (e.g., Eichenbaum, AER 1989) into an otherwise standard DSGE model. We show that firms facing idiosyncratic cost shocks have incentives to bunch production and smooth sales by carrying inventories. The optimal inventory target of a firm is derived explicitly. The model is broadly consistent with many of the observed stylized facts of aggregate inventory fluctuations, such as the procyclical inventory investment and the countercyclical inventory-sales ratio. In addition, the model yields novel predictions for the role of inventories in macroeconomic stability: Inventories may not only greatly amplify but also propagate the business cycle. That is, the incentive to accumulate inventories under the cost-smoothing motive can give rise to hump-shaped output dynamics and significantly higher volatility of GDP. Such predictions are in sharp contrast to the implications of the recent general-equilibrium inventory literature (e.g., Khan and Thomas, 2007; and Wen, 2008), which shows that inventory investment induced by traditional mechanisms (e.g., the stockout-avoidance motive and the (S,s) rule) does not increase the variance of aggregate output.
