Transaction Demand for Money Theory

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Inventory Approach to the Demand for Transaction Balances:

An extension of the basic transaction demand for money theory is that set out by Baumol (1952) and further extended by Tobin (1956). The major underpinning of the inventory approach is that individual’s face a trade-off, between the liquidity offered by money balances, and the interest offered by bond holdings. The models determinants are therefore the nominal interest rate, the level of real income that relates to the desired number of transactions and the transaction costs of transferring money to bonds and vice versa, which are assumed fixed.

An individual’s amount and timing of expenditure is assumed to be known with certainty, and as such payments are spread throughout the income period, with T days producing an expenditure of 1/T∙(individual income per period). Bonds are also assumed to exist, where holding money assets incurs an opportunity cost of forgone interest. Finally the income period of T days is further divided into K equal intervals, each lasting T/K days.

At the beginning of the income period, to ensure adequate money holding for consumption transactions, 1/K of income is retained as money. The remaining balance (K-1/K ∙Y), is used to purchase interest bearing bonds, producing an average money holding of ( Y/2∙1/K). A further factor in the model is that the cost of transacting money out of bonds and vice versa is bK, therefore the less time the average cash balance is held, the more frequently bonds are sold and the higher overall transaction costs; the less money balances that are held, the more brokerage costs will be.

The inventory approach produces five main predictions from its deductions. The quantity of money in an economy is determined by ...

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Serletis, A., (2007). ”The demand for money theoretical and empirical approaches.”, New York: Springer.

Tobin, J., (1956). “The Interest Elasticity of the Transactions Demand for Cash”, Review of Economics and Statistics, Vol. 38(3), pp. 241-247.

Tobin, J., (1958). “Liquidity Preference as a Behaviour Toward Risk”, Review of Economic Studies, Vol. 25(1), pp. 65-86.

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