• William J. Baumol and James Tobin have critically examined the Liquidity Preference Theory and extended it. • The Inventory Theoretic Approach to Demand for money relaxes Keynes’s assumption that the demand for money is linear. This extension estimates the cost of holding money and the cost of holding bonds and minimize the total cost of holding these forms of assets as wealth. • The cost of holding money is the interest payment forgone. The cost of holding bonds include the brokerage fee, travel cost, time cost, and loss of liquidity. • When these costs are minimized then demand for money will be positively related to brokerage fee, inversely related to interest rate and positively related to income. • The objective elements of this extension are the cost elements associated with holding money and/or bonds. • Baumol points out that Money demand function is not linear. Extensions to Keynesian Demand for Money: Summary of Tobin’s Explanation using REA • James Tobin also further examined the Keynesian demand theory immersing into the Regressive Expectation Approach. • The theory of regressive expectations to interest rates postulates that economic entities have a certain level of critical or normal interest rates for which they expect movements in interest rates to ultimately converge to. • Any time the current level of market interest rate is above that critical level, they expect interest rate to fall back to that normal level in the future and when the current level of market interest rate is below that critical or normal level of interest rate, they expect the rate to increase to that normal level in the future. • We also know that the price of bonds and interest rates are negatively related. A rise in the price of bonds will yield capital gains and a fall will yield capital loss. Individuals therefore will hold money or not hold money in order to take advantage of possible capital gains or to avoid capital loss. REA and Demand for Money • Whenever the current market interest rate is higher than the critical, they will expect it to fall to the critical implying they expect the price of bonds will increase in the future to yield capital gains. To earn this expected capital gains, they will hold all bonds (or more bonds) and no money or less money. Therefore demand for money will fall.
• When on the other hand the current interest rate is lower
than the normal or critical, they will expect it to rise to the critical normal level implying they expect the price of bonds will decrease in the future to yield capital loss. To avoid this expected capital loss, they will hold all money (or more money) and no bond or less bonds. Therefore demand for money will increase.
• This is the crux of Regressive Expectations Approach to
demand for money. Tutorial or Practice Questions • 1. Discuss how regressive expectations to interest rates determine whether money is held as a store of wealth or bonds. • 2. Outline the costs associated with holding bonds in comparison with the benefits of holding money. • 3. Are expectations of making capital gains or capital loss important in determining demand for money? How? • 4. What is the relationship between brokerage fee and demand for money? Why?