Inventory investment refers to a firm’s expenditure on stocks of raw materials, finished and semi-finished goods and on work in progress. When a firm spends more of its funds on accumulation of additional inventories, i.e., on holding bigger stocks of inputs and outputs, obviously these funds get blocked and thus cannot be used elsewhere to earn income. If these funds had been invested in inventories, they could have been given as loans to others to earn money at the going rate of interest. The rate of interest thus represents the opportunity cost of holding the given stock of inventories. Thus, the higher market rate of interest means higher opportunity cost of inventory holdings and the consequent disincentive for inventory accumulation. As a result, Investment in inventories will be lower at a higher interest rate. Conversely, a lower interest rate will mean lower opportunity cost of holding inventories thus resulting in a higher investment in accumulation of inventories.
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