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EXTENSIONS TO KEYNESIAN DEMAND FOR MONEY:

Summary of Baumol’s Inventory Theoretic Approach


• 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?

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