(For an updated version of this working paper, see WP 06-6)
Whether or not inventories can be used to break the link between production and sales is crucial for understanding firms' employment response to productivity shocks. In a Taylor-type sticky-price model with inventories, we show that the employment response to a productivity shock depends on the extent to which goods are storable. Whereas in conventional sticky-price models without inventories, productivity shocks reduce employment, the same shocks cause firms in our economy to expand output relative to sales, build up inventories and, as a result, hire more workers. We then estimate the employment response to productivity shocks in disaggregated U.S. manufacturing data from 1958 to 1996. Consistent with our theory, we find that an industry's employment response to productivity shifts is strongly correlated with measures of inventory holding costs.