Economics • Economic BasicsHard
Analyze the implications of the 'Baumol-Tobin Model' of cash management. How does an increase in brokerage fees for converting bonds into cash affect the optimal average cash holding of an individual?
A. It reduces optimal cash holdings because individuals prefer holding interest-bearing assets
B. It increases optimal cash holdings as the transactional cost of moving between cash and bonds rises✓ Correct Answer
C. It has no impact on cash holdings since money demand depends solely on the real GDP level
D. It causes individuals to abandon bonds entirely and hold all wealth in foreign currencies
💡 Solution & Explanation
The Baumol-Tobin inventory-theoretic approach shows that optimal cash balances vary directly with brokerage transaction costs and inversely with the nominal interest rate. Higher brokerage fees make frequent portfolio adjustments expensive, prompting individuals to hold larger average cash amounts. The model successfully explains the economies of scale in money demand at the aggregate macroeconomic level.
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