The Income and Interest Elasticity of the Transactions Demand for Cash

Abstract

The classical partial equilibrium inventory approach developed by Baumol (1952) and Tobin (1956) predicts the interest and income elasticity are both equal to a constant of 0.5. This paper shows that in a general equilibrium inventory theoretic framework, first, the income elasticity of money is one, rather than 0.5. This is due to incorporation of the value of the time into the model. Second, the interest elasticity has two values depending on a threshold interest rate. When interest rates are below this threshold, the model is the Cash-In-Advance model with a constant income velocity of money and zero interest elasticity; otherwise the interest elasticity is close to 0.5 and the velocity fluctuates in response to variations in interest rates. Finally, the general equilibrium elasticity results are robust across alternative specifications of the agent's utility.