(For an updated version of this working paper, see WP 06-6)
We study the implications of nominal price rigidities in a model where firms use inventories to smooth production because of increasing marginal cost. Conventional criticisms of production smoothing models have focused on their inability to replicate the following two stylized facts: (1) inventory investment is positively correlated with sales and, therefore, production is more volatile than sales, (2) movements in inventory-sales ratios are persistent. In contrast, we show that a standard production smoothing model of inventory behavior is consistent with these facts when prices are sticky. Furthermore, these results hold irrespective of whether the economy is driven by nominal demand or real supply shocks. It has also been suggested that increasing short-run marginal cost at the firm level can make the effects of nominal shocks more persistent. We show that if firms can hold inventories nominal demand shocks will have lasting effects on sales, but not necessarily on production.