BAUMOL TOBIN MODEL PDF

According to the transaction theory, money is a dominated asset people hold money unlike other assets, to make purchases. Money has both cost and benefit. Cost is the low rate of return and benefit is that, it makes transactions more convenient. So people decide how much money to hold by trading off these costs and benefits. Baumol-Tobin was not satisfied with Keynes treatment of demand for money so he developed the model of cash management in in which he explained the costs and benefits of holding money.

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According to the transaction theory, money is a dominated asset people hold money unlike other assets, to make purchases. Money has both cost and benefit. Cost is the low rate of return and benefit is that, it makes transactions more convenient. So people decide how much money to hold by trading off these costs and benefits. Baumol-Tobin was not satisfied with Keynes treatment of demand for money so he developed the model of cash management in in which he explained the costs and benefits of holding money.

Baumol-Tobin model shows that demand for money depends positively on the income level and negatively on the interest rate. This model is explained in terms of assets.

An individual holds portfolio for monetary assets currency and checking account and non-monetary assets stocks and bonds. The optimum amount of asset he can hold will depend on the cost considerations: i Interest forgone on the cash balance held, and ii Cost of acquiring bonds and converting them into cash, i.

When people hold money they incur both benefit and cost. Benefit is the convenience which they get by avoiding making a trip to the bank every time they wish to buy something. But the cost of this convenience is the forgone interest which they would have earned if they had deposited the money in the saving accounts. There is, thus, a trade off between benefits and costs. If one holds large amount of monetary assets, interest forgone will be very high but if one holds less cash, then the interest forgone will be less but the transaction cost of holding bonds, i.

To avoid these extreme situations, people will hold both monetary and non-monetary assets to minimize the cost. Price level is constant 2. Transactor has a given income. Real spending is constant over the year, that is, an individual spends uniformly over the year. Transaction funds can be held either in money or in interest yielding bonds. X plans to spend Rs. Y gradually over a year. There are different possibilities: 1st Possibility: Mr.

He withdraws the entire amount Rs. Y at the beginning of the year and spend it gradually. Since his average holdings are less, he forgoes less interest but the disadvantage is that he had to make two trips to the bank. He makes N trips to the bank over the time period of one year. But, as N increases, the inconvenience of making frequent trips to the bank increases.

As the number of trips to the bank increases, the amount of interest forgone decreases Fig. However, as the number of trips to the bank increases, the cost of visit increases. Therefore, the FN curve is positively sloped. Thus, Baumol-Tobin model shows that demand for money is not only a function of income level but also the interest rate. Implication of the Model: If the fixed cost of going to the bank F changes, the money demand function changes.

Thus, although the model gives us a very specific money demand function, it may not be necessarily stable over time. Baumol-Tobin model held that: a Income elasticity of demand for money is half. The Model failed because some people have less discretion over their money holdings than the model assumes. Empirical studies of money demand find that the income elasticity of money demand is greater than half and the interest elasticity of money demand is less than half. Thus, the model is not completely correct.

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