Economics • Economic BasicsHard
Analyze the implications of the 'Baumol-Tobin Model' of cash management for transactional money demand. How does transactional money demand respond to changes in the prevailing interest rate?
A. It varies inversely with the square root of the interest rate, showing economies of scale in cash holdings✓ Correct Answer
B. It varies directly and proportionally with the interest rate due to higher opportunity costs of liquidity
C. It remains entirely unresponsive to interest rate fluctuations because cash serves solely medium-of-exchange needs
D. It varies inversely and proportionally with the interest rate according to classical quantity theory assumptions
💡 Solution & Explanation
The Baumol-Tobin model applies inventory-theoretic principles to transactional money demand, demonstrating that cash holdings vary inversely with the square root of the interest rate. Households and firms balance the brokerage costs of transferring funds between interest-bearing assets and cash against the foregone interest of holding money. Because of fixed transaction costs, individuals make multiple optimal trips to financial institutions, creating economies of scale in cash management. Consequently, the interest elasticity of money demand in this model is negative zero point five.
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