The Critically Evaluation of the Baumol – Tobin Inventory Theory of Money Demand

اقتصاد پولی مالی

Article 10, Volume 23, Issue 12, February 2017, Pages 217-234   

Document Type: پژوهشی

DOI: 10.22067/pm.v23i12.45376

Author

Mostafa Karimzadeh^*

Ferdowsi University of Mashhad

Abstract

Money is the one of the most important human innovations that has essential role in facilitating of transactions and economic evolution. Which added its performance with development and complicated of societies. The money market has like all other markets, both a demand side and a supply side. In this paper we examine the demand side. Since the 1930s, economists have developed the theory underlying the demand for money along several different lines, each of which provides a different answer to the basic question: If bonds earn interest and money doesn’t, why should a person hold money? While the way the various theories this question differs, in general they come down to a demand for money function.
The cognition of effective factors on money demand is one of the most important economic topics. To answer this problem, some of the economists try to present several money demand theories. In this paper we will evaluate the inventory approach to transaction demand developed by both Baumol and Tobin. They show that there is a transactions need for money to smooth out the difference between income and expenditure streams and the higher the interest rate – the return on holding bonds instead of money – the smaller these transactions demand balances should be.

Theoretical Framework
Keynes had designated the transactions demand for money as due to the transactions motive but had not provided a theory for its determination. In particular, he had assumed that this demand depended linearly on current income but did not depend on interest rates.
Subsequent contributions by Baumol and Tobin in the 1950s established the theory of the transactions demand for money. These contributions showed that this demand depends not only on income but also on the interest rate on bonds. Further, there are economies of scale in money holdings. The transactions demand for money is derived under the assumption of certainty of the yields on bonds, as well as of the amounts and time patterns of income and expenditures.
Baumol (1952) and Tobin (1956) presented their money demand theory by using inventory approach. Developments since the 1950s have extended and broadened the Baumol–Tobin transactions demand analysis, without rejecting it. The most significant extension of this analysis has been to the case where there is uncertainty in the timings of the receipts and payments. The demand for money under this type of uncertainty is usually labeled as the precautionary demand for money. This section presents Baumol’s (1952) version of the inventory analysis of the transactions demand for money. This analysis considers the choice between two assets, “money” and “bonds,” whose discriminating characteristic is that money serves as the medium for payments in the purchase of commodities whereas bonds do not; hence, commodities trade against money, not against bonds. There is no uncertainty in the model, so the yield on bonds is known with certainty. The real-world counterpart of such bonds is interest-paying savings deposits or such riskless short-term financial assets as Treasury bills. Longer-term bonds whose yield is uncertain are not really considered in Baumol’s analysis. Baumol’s other assumptions are:
1. Money holdings do not pay interest. Bond holdings do so at the nominal rate R. There are no own-service costs of holding money or bonds, but there are transfer costs from one to the other, as outlined later. Bonds can be savings deposits or other financial assets.
2. There is no uncertainty even in the timing or amount of the individual’s receipts and expenditures.
3. The individual intends to finance an amount $Y of expenditures, which occur in a steady stream through the given period, and already possesses the funds to meet these expenditures. Since money is the medium of payments in the model, all payments are made in money.
4. The individual intends to cash bonds in lots of $W spaced evenly through the period. For every withdrawal, he incurs a “brokerage (bonds–money transfer) cost” that has two components: a fixed cost of $B0 and a variable cost of B1 per dollar withdrawn. Examples of such brokerage costs are broker’s commission, banking charges and own (or personal) costs in terms of time and convenience for withdrawals from bonds. The overall cost per withdrawal of $W is $(B0 +B1W).
They explained that individuals have two cost about money demand: the cost of interest rate of money (first cost) and the cost of refer to bank (second cost). The most important contribution of their theory is that interest rate influences transactions demand of money.

Results & Discussion
Our paper lead to this occlusion that development of electronic money and banking, causes the Baumol – Tobin theory faces essential critical and challenges. In recent age with development of electronic money and banking, the cost of refer to the bank is very low.


Conclusion & Suggestion
Hence we can assume that this cost is zero. By assumption that the cost of refer to the bank is zero, the inventory theory isn’t appropriate approach to money demand.

Keywords

Money Demand; Inventory; Baumol – Tobin; Electronic money; Cost of refer to the bank

References

[1] Ezadi, Hamid Reza & Dahmardeh, Nazar. (2012). Relation Between Monetary and Fiscal Policies and The stability of Money Demand Function and its Forecasting in Iran. Quarterly Applied Economic Studies in Iran, Volume, 1, Number, 1, pp 165-190. (In Persian)

[2] Branson, William H. (1997). Macroeconomic Theory and Policy. Translated by Abbas Shakeri. Ney Press. (In Persian)

[3] Blanchard, Oliver Jean and Fisher, Stanly. (1998). Lectures on Macroeconomic. Massachusetts Institute of Technology. Translated by Mahmood Khataie & Teymoor Mohammadi. Budget and Planning Press. (In Persian)

[4] Tari, Fat Alah & Shapoori, Abdol-Reza. (2112). The Effect of Development of E-Payment Instruments on Money Demand. . Quarterly of Economic Research of Iran, No, 51, pp 1-19. (In Persian)

[5] Davvodi, Parviz & Samsami, Hossein. (2009). The Economics of Money and Banking. University of Shahid Beheshti Press. (In Persian)

[6] Davvodi, Parviz ; Nazari, Hasan & Mirjalili, Seyed-Hossein. (1995). Money in Islamic Economics. Samt Press. (In Persian)

[7] Rahmani, Teymoor. (2004). Macroeconomic, Vol, 2, Baradaran Press. (In Persian)

[8] Shakeri, Abbas. (2010). Macroeconomic Theories and Policies. Vol, 2. Rafe Press. (In Persian)

[9] Mojtahed, Ahmad & Hasanzadeh, Ali. (2005). Money & Banking and Financial Institutions. Monetary and Banking Research Academy Central Bank of the Islamic Republic of Iran. (In Persian)

[10] Noferesti, Mohammad. (2011). Population Development and Demand for Money in Iran. Tend of Economic Research, Volume, 19, Number, 58, pp 15-32. (In Persian)

[11] Blanchard, Oliver Jean and Fisher, Stanly. (1989). Lectures on Macroeconomic. Massachusetts Institute of Technology, The MIT Press.

[12] Baumol, William. (1952). The Transactions Demand for Cash. Quarterly Journal of Economics 67, 4, 545-556.

[13] Tobin, James. (1956). The Interest Elasticity of the Transactions Demand for Cash. Review of Economics and Statistics 38, 241-247.

[14] Keynes, John Maynard. (1936). The General Theory of Employment, Interest and Money. New York: Harcourt, Brace and Company.