The Critical Evaluation of the Baumol - Tobin Inventory Theory of Money Demand

Money is one of the most important human innovations that has an essential role in facilitating transactions and economic evolution. Which added its performance with the development and complexity 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 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 does not¡ why should a person hold money? While the way various theories approach this question differs¡ generally they come down to a demand for money functions.
The issue of effective factors on money demand is one of the most important economic topics. To solve 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 transactional need for money to smooth out the differences 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 from 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 using inventory approach. Developments since 1950s have extended and broadened Baumol–Tobin transactions demand analysis¡ without rejecting it. The most significant extension of this analysis has been in 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 another¡ 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 occurs 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 ݕ).
They explained that individuals have two costs about money demand: the cost of interest rate of money (first cost)¡ and the cost of referring to bank (second cost). The most important contribution of their theory is that interest rate influences transactions demand of money.
Our paper led us to this conclusion that development of electronic money and banking¡ causes the Baumol – Tobin theory to face essential critical and challenges. In recent age with development of electronic money and banking¡ the cost of referring to the bank is very low.
Conclusion & Suggestion: Hence¡ we can assume that this cost is zero. Assuming that the cost of referring to the bank is zero¡ the inventory theory is not an appropriate approach to demand money.