BAUMOL-TOBIN MODEL OF TRANSACTIONS

MONEY DEMAND
Propounded by Baumol (1952) and Tobin (1956) to
draw more precise implications about the variables
that determine the demand for transaction balances.

Transactions balances are a sort of inventory, which

the holders keep in order to finance transactions
usually predictable and often routine, as and when
they arise.

Money is held in transactions balances because it is

convenient to do so.

But holding transactions balances also involves an

opportunity cost in terms of foregone interest income
if money put in interest - bearing investment.

The demand for cash as an inventory can be analyzed

in two stages:
 Stage 1: Agent receives an income (Y) for
transactions for a given period and decides how
much to retain as cash (R) and bonds (K):
Baumol – Tobin Model of Money Demand Page 1
 Y=R+K
Where: Y = Income
R = Cash retained
K = Bonds

 For the first part of the period, transactions

financed by retained cash balances.

 Interest foregone by holding R cash balances:

( Y −K
2 ) ( Y −K
Y )
r
where:
r = interest rate

(Y – K)/2 = Average cash holding in first part of

transactions period

(Y- K)/Y = Proportion of income held in cash

Baumol – Tobin Model of Money Demand Page 2

 
Encashment costs (brokerage fees, stamp duty)

in period 1: α + βK

 The total combined costs are:

Y −K Y −K
(
r 2 ) ( Y ) + α +βK

 Stage 2: Agent determines amount (X) to

encash each time based on the transactions
expenditure flows in second part of the period.

 For each encashment of X amount, the interest

X K
foregone will be r 2)
( Y

 Brokerage costs plus interest foregone in the second

part of the transactions period l:
X K K
r 2)
( (∝+ βX )
Y + X

Where: X = Amount encashed each time

K/X = the number of encashments

Baumol – Tobin Model of Money Demand Page 3

 X K
r( )
2 Y
= Interest foregone
K
(∝+ βX )
X
= Brokerage costs

Baumol – Tobin Model of Money Demand Page 4

 Total transactions costs for period:
Y −K Y −K X K K
(
C=r 2 ) ( Y ) + α + βK + r 2 )
( Y +
(∝+ βX )
X

By opening up brackets:
r (Y −K )2 rXK αK
C= + α + βK + + + βK
2Y 2Y X

r (Y −K )2 rXK αK
C= + α +2 βK + +
2Y 2Y X

The optimal bond holding and encashment is

obtained by minimizing the total cost with respect to
X & K. First order conditions:
∂C rK αK
∂X = 2Y - X2 =0
rK αK
=
2Y X 2

X 2 rK =2 αKY

2 αKY
X2=
rK

Baumol – Tobin Model of Money Demand Page 5

 2 αY
X2=
r

X= ( 2 αYr ) 1/2

∂C −r (Y −K ) Xr α
∂K = Y + 2β + 2Y + X =0

2 βY
r
Solving for K = Y-X-
2 βY
Therefore, R = Y-K = X + r

The optimum average transactions demand for

money for the whole of the transactions period which
is a weighted average of the optimum average cash
balances for both parts of the transactions period:

M =d
R
2 ( Y −K
Y ) +
XK
2Y

Substituting for X & R we obtain

2
αY 1 2β β
Md = ( )
2r 1/2 ( +
K r ) +2Y ()
r

Baumol – Tobin Model of Money Demand Page 6

 ∂ Md αY −0.5
Y 1 2β
∂α = 0.5( )
2r( 2 r )( K r )
+ >0

d
∂M
¿
∂β =

Implications for Transactions Money Demand:

An increase in brokerage costs increases the demand
∂ Md ∂ Md
for transactions cash balances: ∂α ;
>0
∂β
>0

If α = β = 0 , demand for transactions cash balances

would be equal to zero

An increase in interest rates increases the opportunity

cost of holding cash, hence reduces demand for
∂Md
transactions cash balances: ∂r
<0

 Demand for money = f(brokerage costs, interest

rates)

Baumol – Tobin Model of Money Demand Page 7