Definition of Monetary Economics - Essay Example

?Monetary Economics Table of Contents 0.Introduction 3 2.0.Transaction Demand for Money 4 2 Transaction Demand and Interest Rate 4 3.0. Baumol-Tobin Approach to Transaction Demand for Money 6 3.1 Empirical Illustration 7 4.0 Empirical Evidence 11 5.0 Conclusion 12 References 13 1.0. Introduction The research paper is a comprehensive study on the reasons of belief that transaction demand for money may be interest elastic. It is true that no interest is provided for holding money. In spite of the fact, people hold money. This is for the three main reasons: transaction demand, precautionary demand and speculative demand. The area of concern in this research paper is to evaluate the transaction demand for money. The transaction demand for money is the money held for purchasing everyday goods from the market. Transaction demand for money for the individuals is initiated by their requirements of paying rent, mortgage payments, monthly bills, and car payments among others (Tata McGraw Hill Companies, 2002). Transaction motive of holding money is initiated also among businesses as the business houses require money in their accounts for meeting their payrolls and paying the bills. Before discussing the reasons as to why it is believed that transaction demand for money is interest elastic, it is essential to discuss the relationship that interest rates have on the demand for money. The demand for money or the quantity of money held decreases with the increase in the interest rates. The substitute or the alternative for holding assets other than the form of money is to hold them as a certain form of paper that bears interest. Thus, as the interest rate is increased, the attraction towards the assets increases and urges to hold money decreases (Tata McGraw Hill Companies, 2002). After the brief discussion on how the transaction demand for money can possibly become interest elastic, it will be easier to understand the reason behind the belief. 2.0. Transaction Demand for Money According to Keynes, transaction demand for money relates to “the need of cash for the current transactions of personal and business exchange”. The transaction motive is further divided into income motive and business motive. The motive of income is aimed at bridging the interval between the income receipt and disbursements. In the same manner, business motive is the bridging of interval between the costs incurred in business and the receipts of the proceeds of the sales. In both the cases, if the interval is less, then individuals will strive to hold less cash or the transaction demand for money will be less and vice-versa. Thus, it is evident that the transaction demand for money has a ‘direct positive relationship’ with the level of income (SVMMBA, 2010). 2.1. Transaction Demand and Interest Rate Keynes did not explain the importance of the interest rates in the analysis of his part of the theory of demand for money. However, in the later years, two of the post Keynesian economists, James Tobin and William J. Baumol have depicted the importance of interest rates as a determinant of the transactions demand for money. These economists have mentioned that there is no linear and proportional relationship between the income and transaction demand for money. According to them, income changes lead to smaller amount of proportional changes in the transaction demand for money (SVMMBA, 2010). Individuals hold transaction balances because income that is received only once in a month is not spent by them in a single day. In fact, this is the common nature of the individuals that they spread evenly the expenditure over the period of the month. Thus, a part of the money that is meant for the purpose of transaction spending can be invested or spent on short-term securities that yield interests. It is likely to put the funds for the purpose of making them work for a few days, say a week, ten days or even a month. The investment can be on short term interest bearing securities such as short-term money market instruments or commercial papers and so on. One hurdle is that there is an involvement of cost with the buying and selling of the securities. The individual needs to weigh the inconvenience and financial cost of repeated entry and exit from the market for securities and realise the apparent advantage achievable from the holding of securities bearing interest instead of holding dormant transaction balances. Apart from the realisation of this fact, the rate of interest, the cost per sale and purchase and the frequent incidences of purchase and sale resolve the profitability of transforming the preferences of holding transaction balances to assets that earn wealth. The rate of interest that can be earned from the switching phenomenon is absolutely higher than the cost of sale and purchase. The higher the rate of interest, the larger will be the proportion of any specific balances of transaction amount that can be usefully redirected to securities (SVMMBA, 2010). 3.0. Baumol-Tobin Approach to Transaction Demand for Money The approach that has been led by Baumol and Tobin in the modern economists’ era illustrates the belief that transaction demand for money is interest-elastic. The approach is also known as ‘Inventory Theoretic Approach’. The approach evolved as an improvement to the Keynesian theory towards the transaction demand for money. There are chiefly two points that produced the improvement: Baumol and Tobin, unlike Keynes considered the precautionary, transaction and speculative demand for money together because for all purposes, money is held as ‘real cash balance’ Keynes depicted the relationship of demand for money with the interest and income; whereas Baumol and Tobin introduced another variable which is the cost associated with the transformation of real cash balance to bonds that bear interest (Sprenkle, 2011) Baumol-Tobin with the use of sophisticated analysis of the behaviour of the bondholders, have proved that the transaction demand for money is income-elastic. For proving this point of view, the two economists, especially Baumol had used the approach of business inventory. The business units, for facilitating the business transaction, hold cash balances. The cash balances consist of an opportunity cost that is in the form of the loss of interest. Thus, the business houses hold an optimum amount of cash balance that helps in minimising the opportunity cost. This same approach has been applied by Baumol for analysing the individuals’ behaviours with respect to the holding of bonds and the cash balance. The following assumptions have to be considered for understanding Baumol’s approach: An individual, be it a firm or household, obtains income only once in an unit of time, annually, monthly or weekly but he spends this income regularly over the period of time The spending of the expenditure is made uniformly over the limit of time of the receipt of income, for example, if an individual spends a total amount of ?1000 in as month, then in a week he spends ?250 The combination of bond and cash is made by the individual with the aim of minimising the cost The carrying out of asset transaction is undertaken by the individual in an environment of uncertainty 3.1 Empirical Illustration On the basis of the assumptions mentioned above, let it be supposed that an individual earns income (Y) on a yearly basis on January 1st each year. On receiving the income, the individual converts them into bonds that yield income. Let it be assumed that the individual has the opportunity of buying and selling bonds instantly and it is not required by him to hold balances of cash other than his needs for transaction. If the individual holds the idle balance of cash, the interest on it over the years is lost by him along with the decrement in the cash balance. Therefore, it is logical and rational for the individual to buy certain income yielding bonds and at times of necessities sell those for earning. However, two kinds of costs are associated with the choice of the bonds: Bond transaction cost that includes the fee of the broker, telephone expenses, travelling cost to the bank and so on The cost of interest loss on conversion of the bonds to cash Considering the bond transaction cost, if the individual spends all his income in bonds, re-acquiring of his income over the period of one year will be essential by a number of sales on bonds. If the selling is done through a broker, then the individual would have to incur transaction cost or the non-interest cost each time the selling is performed. Let the value of the bond be M1 that will be turned into cash for the purpose of meeting the transaction demand for money. If b is the fixed rate of transaction cost, then the total cost of transaction (C1) can be expressed as below: C1 = b(Y/M1) Now, with respect to the interest cost, the individual or the bondholder will lose interest on converting the bonds into cash. Let this be supposed that bonds bearing an equal value (M1) are transformed into cash at regular points of time, for example, on the first day of every month. On the conversion of bonds into cash each month, the individual accumulates loss on the interest on an increasing balance of cash that is acquired by him on selling of the bonds. On an average, interest that is half of his income is lost by the individual, Y/2. Thus, the cost of interest (C2) can be expressed as follows: C2 = i (Y/2); Where,’ i’ is the rate of interest. Thus, there are two components in the total operational cost (C), C1 and C2. C = C1 + C2 C = b(Y/M1) + i(Y/2) There arises a question that asks how the individual will take up the combination of the portfolio of bonds and cash for the purpose of minimising his ultimate cost (C). The answer to this question can be found out by an assumption of a provided rate of interest and by taking the derivative of the equation of total cost with respect to M1 and then setting the equation on Zero and thus solving for M1. Thus, ?C/?M1 = -(bY/M12) + i/2 = 0 This means i/2 = bY/M12 or, M12 (i) = 2bY or, M1 = v(2bY/i) or, M1 = (2bY)1/2 x i-1/2 Since M1/2 is the average holding of money, the transaction demand for money can be derived through division of both the sides by 2, i.e. M1/2 = v (bY/2i) The above obtained demand function of money determines two things: The transaction demand for money is dependent on the interest rate, the bond transaction cost and the income level The transaction demand for money has an inverse relationship with the square root of rate of interest and has a direct relationship with the square root of income (Dwivedi, 2005) This means that if the rate of interest is increased by 10%, then there will be a decrement in the transaction demand for money by 5%. On the other hand, if the income rises by 10%, then the transaction demand for money will also increase by5%. From this, the following conclusions can be drawn up from the entire discussion of the transaction demand for money: The transaction demand for money is interest elastic, and The transaction demand for money increases on a proportion with the increase of income 4.0 Empirical Evidence One of the early studies of James Tobin shows the linkage between the demand for money and interest rates with the use of the U.S data. Transaction balances were separated from the money balances by Tobin which he called “idle balances”. It was assumed that transaction balances are proportional to alone income and idle balance has a relation with alone interest rates. Tobin then observed as to whether the measure for idle balances is related inversely to the rates of interest during the period from the year 1922 to 1941. This was done by him by plotting the average idle balances of each year along with the average rates of interest on commercial paper in the particular year. There he observed an inverse relationship between the idle balances and rates of interests. Thus, it was concluded by Tobin that the demand for money is interest elastic (Pearson Education, 2002). 5.0 Conclusion From the discussion related to the research topic as to find out the reasons for the belief that the transaction demand for money may be interest elastic, it is evident that the transaction demand for money is directly related to the level of income and is indirectly related to the rate of interest. The theoretical perspective of the approach has been discussed in the research paper and has been supported by precise empirical evidence along with empirical illustration. The various approaches towards the findings of the research problem suggest that the demand for money is actually interest elastic. It would be prolific to mention that the ultimate assumption of the belief about the fact is dependent on the perception of the individual regarding the holding of cash balances. But then it is also true that the provision of the rate of interest on bonds acts as an infusion on the perception of the individuals. References Dwivedi, D. N., 2005. Macroeconomics: Theory and Policy. Tata McGraw-Hill. Pearson Education, 2002. Empirical Evidence on the Demand for Money. Objects. [Online] Available at: http://wps.aw.com/wps/media/objects/3000/3072002/appendixes/ch19apx2.pdf [Accessed February 15, 2011]. Sprenkle, M., 2011. Large Economic Units, Banks, and the Transactions Demand for Money. The Quarterly Journal of Economics. [Online] Available at: http://www.jstor.org/pss/1880729 [Accessed February 15, 2011]. SVMMBA, 2010. The Demand for Money. Downloads. [Online] Available at: http://www.svmmba.com/downloads/23.pdf [Accessed February 15, 2011]. Tata McGraw Hill Companies, 2002. Demand for Money. Power Points. [Online] Available at: http://faculty.riohondo.edu/mjavanmard/Slavinpowerpoint/powerpoints/money/DemandMoney.pdf [Accessed February 14, 2011]. Read More