BAUMOL-TOBIN MODEL OF TRANSACTIONS
MONEY DEMAND
Propounded by Baumol (1952) and Tobin (1956) to
draw more precise implications about the variables
that determine the demand for transaction balances.
Transactions balances are a sort of inventory, which
the holders keep in order to finance transactions
usually predictable and often routine, as and when
they arise.
Money is held in transactions balances because it is
convenient to do so.
But holding transactions balances also involves an
opportunity cost in terms of foregone interest income
if money put in interest - bearing investment.
The demand for cash as an inventory can be analyzed
in two stages:
Stage 1: Agent receives an income (Y) for
transactions for a given period and decides how
much to retain as cash (R) and bonds (K):
Baumol – Tobin Model of Money Demand Page 1
Y=R+K
Where: Y = Income
R = Cash retained
K = Bonds
For the first part of the period, transactions
financed by retained cash balances.
Interest foregone by holding R cash balances:
( Y −K
2 ) ( Y −K
Y )
r
where:
r = interest rate
(Y – K)/2 = Average cash holding in first part of
transactions period
(Y- K)/Y = Proportion of income held in cash
Baumol – Tobin Model of Money Demand Page 2
Encashment costs (brokerage fees, stamp duty)
in period 1: α + βK
The total combined costs are:
Y −K Y −K
(
r 2 ) ( Y ) + α +βK
Stage 2: Agent determines amount (X) to
encash each time based on the transactions
expenditure flows in second part of the period.
For each encashment of X amount, the interest
X K
foregone will be r 2)
( Y
Brokerage costs plus interest foregone in the second
part of the transactions period l:
X K K
r 2)
( (∝+ βX )
Y + X
Where: X = Amount encashed each time
K/X = the number of encashments
Baumol – Tobin Model of Money Demand Page 3
X K
r( )
2 Y
= Interest foregone
K
(∝+ βX )
X
= Brokerage costs
Baumol – Tobin Model of Money Demand Page 4
Total transactions costs for period:
Y −K Y −K X K K
(
C=r 2 ) ( Y ) + α + βK + r 2 )
( Y +
(∝+ βX )
X
By opening up brackets:
r (Y −K )2 rXK αK
C= + α + βK + + + βK
2Y 2Y X
r (Y −K )2 rXK αK
C= + α +2 βK + +
2Y 2Y X
The optimal bond holding and encashment is
obtained by minimizing the total cost with respect to
X & K. First order conditions:
∂C rK αK
∂X = 2Y - X2 =0
rK αK
=
2Y X 2
X 2 rK =2 αKY
2 αKY
X2=
rK
Baumol – Tobin Model of Money Demand Page 5
2 αY
X2=
r
X= ( 2 αYr ) 1/2
∂C −r (Y −K ) Xr α
∂K = Y + 2β + 2Y + X =0
2 βY
r
Solving for K = Y-X-
2 βY
Therefore, R = Y-K = X + r
The optimum average transactions demand for
money for the whole of the transactions period which
is a weighted average of the optimum average cash
balances for both parts of the transactions period:
M =d
R
2 ( Y −K
Y ) +
XK
2Y
Substituting for X & R we obtain
2
αY 1 2β β
Md = ( )
2r 1/2 ( +
K r ) +2Y ()
r
Baumol – Tobin Model of Money Demand Page 6
∂ Md αY −0.5
Y 1 2β
∂α = 0.5( )
2r( 2 r )( K r )
+ >0
d
∂M
¿
∂β =
Implications for Transactions Money Demand:
An increase in brokerage costs increases the demand
∂ Md ∂ Md
for transactions cash balances: ∂α ;
>0
∂β
>0
If α = β = 0 , demand for transactions cash balances
would be equal to zero
An increase in interest rates increases the opportunity
cost of holding cash, hence reduces demand for
∂Md
transactions cash balances: ∂r
<0
Demand for money = f(brokerage costs, interest
rates)
Baumol – Tobin Model of Money Demand Page 7
