BAUMOL’S THEORY OF DEMAND FOR MONEY/THE BAUMOL
-TOBIN MODEL OF CASH
MANAGEMENT/BAUMOL’S INVENTORY THEORETIC APPROACH
/THE INTERESTELASTICITY OF TRANSACTION DEMAND FOR MONEY/PORTFOLIO BALANCE
APPROACH/BAUMOL’S SQUARE ROOT FORMULA FOR DESCRIBING DEMAND FOR
MONEY
Keynes had designated the transaction demand for money as due to the transactionmotive but had not provided a theory for its determination. In particular, he had assumedthat this demand depended linearly on current income but did not depend on interest rates.Subsequent contributions by Baumol and Tobin in 1950s established the theory of the transactions demand for money. These showed that this demand depends not only onincome but also on the interest rate on bonds. Further, there are economies of scale inmoney holdings.The transactions demand for money is derived under the assumptions of certaintyabout the yields on bonds, as well as the amount and the time patterns of income andexpenditure.Developments during the 1950s analysed the demand for transactions balancesrigorously from the standpoint of an individual who minimizes the costs of financingtransactions by holding money balances and other assets. This analysis showed that thetransactions demand for money depends negatively upon the rate of interest and that itselasticity with respect to the real level of expenditures is less than unity. The originalanalyses along these lines were presented by Baumol [1952] and Tobin [1956].Modern theories of transactions demand for money originated in the work of Baumol and Tobin, who adopted an inventory theoretic approach. It is based on theexistence of a time lag between payments and receipts, and the presence of short termfinancial assets [say bills] other than money which yield an improved store of value sincethey are earning a rate of interest. The time lags are implicit in specialization and thedivision of labour; the availability of a range of alternative assets depends upon thesophistication of the financial system. In addition there is also a cost involved in switchingin and out of bills. However, if the yield is high enough, transactions costs low enough, andthe transactions period long enough, it will be worthwhile placing some of the moneydesignated for spending during the period into bills.According to this approach, the demand for money can be shown to be a function of therate of interest even in the absence of asset price uncertainty. The relevant behaviouraldeterminants are:
i.
Relative interest rates between money and billsii.
The transfer cost involved in switching between money and bills; andiii.
The length of the payments period.The difference between the two theories developed by Tobin and Baumol is that Baumol assumed only fixed transfer costs, whereas Tobin included a variable cost as well,related to the size of the transaction. Since the results of both approaches are practicallyidentical only the simplest is developed below.According to Keynes, the transactions demand for money is function of the level of income and the relation between transaction demand for money and income is linear andproportional. Further the transaction demand for money is interest inelastic.Prof. Baumol pointed out that the transaction demand for money is also interest elasticlike the speculative demand for money. Further he showed that the relation betweentransaction demand and income is neither linear nor proportional. William Baumol appliedthe capital theory to the analysis of the transaction demand for money. Baumol assumesthat an individual or a firm has an optimum inventory of money for transaction purposes.Cash balances are held by the people, as income and expenditure do not take place,simultaneously. But it is expensive to have large amount of money in the form of cashbalances. That money could otherwise be used profitably elsewhere, for example, in bondsand securities. In this situation, money balances held to make expenditures are consideredas a kind of inventory and the objective of an individual is to minimize the cost associatedwith the inventory.When cash held for expenditure, two types of costs are there:1.
Interest cost [Sacrifice of interest]2.
Non-Interest cost [Conversion Cost or Brokerage Cost]The interest cost is an opportunity cost. When cash balances are held, we foregointerest income by not holding other forms of interest yielding assets. The non-interest costs are mailing expenses, brokerage fees and so on. An individual always tries to keepminimum transactions balances in order to earn maximum interest. So if the interest rateon bonds is high, the lesser the transaction demand for money.
Assumptions
1.
Over any given time period the individual knows his income, Y, with certainty.2.
The time path of expenditures is known and distributed evenly over the periodsumming to T, with Y=T, and that they all have to be paid for with money. Thismeans that over any two sub-periods of equal length the value of transactions willbe identical.
3.
The rate of interest, r, is fixedand known.4.
The cost of switching frombills/bonds to money is a fixedamount, b[what Baumol calls
“the brokerage fee”] reflecting
both subjective and objectivecosts.5.
Individual always transfers thesame quantity of money out of bills each time, K, running thisholding down to zero beforemaking his next withdrawal.i.e., K is the size of each cashwithdrawal at intervals whenbonds are sold.
is the amount of withdrawals that occur overthe year [particular period]There are two types of cost incurredby the market operator.i.
The brokerage charge, which is
, i.e., the brokerage fee times the number of transfers made; andii.
The income foregone by holding money-since expenditure is assumed to be aconstant flow, so that actual money balances are run down evenly over the holdingperiod, the average money balance must be
. The cost is therefore this averageholding times the rate of interest foregone,
.Since transactions are directly proportional to time, the pattern of money holdingover time can be related to the income-expenditure pattern.[In other words, Baumol
takes into account an individual’s demand for money. Suppose‘T’ indicates the transactor’s real income. ‘K’ is the real value of the bonds that thetransactor encashes frequently, ‘b’ is the brokerage for transforming bonds
into cash
and vice versa. The transactor’s real income is given at the beginning of the month and
it gets fully spent up to the end of the month. Now the transactor will try to minimizethis cost of turning bonds into money. The transactor gets income as a lump sum only
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