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On Transactions and Precautionary Demand For Money

Author

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  • Jacob A. Frenkel
  • Boyan Jovanovic
Abstract
This paper develops a stochastic framework for the analysis of transactions and precautionary demand for money. The analysis is based on the principles of inventory managements and the key feature of the model is its stochastic characteristics which lead to the need for precautionary reserves. The formal solution for optimal money holdings is derived and is shown to depend on the rate of interest, the mean rate of net disbursements, the cost of portfolio adjustment and the variance of the stochastic process governing net disbursements. One solution is obtained by minimizing the present value of financial management. This solution is compared with an alternative that is derived from the more conventional methodology of minimizing the steady-state cost function. The comparison shows that the two approaches may yield solutions that differ significantly from each other. The paper concludes with an application of the model to an empirical examination of countries' holdings of international reserves. The empirical results are shown to be consistent with the predictions of the model.

Suggested Citation

  • Jacob A. Frenkel & Boyan Jovanovic, 1978. "On Transactions and Precautionary Demand For Money," NBER Working Papers 0288, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:0288
    Note: ITI EFG IFM
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    References listed on IDEAS

    as
    1. Olivera, Julio H G, 1969. "A Note on the Optimal Rate of Growth of International Reserves," Journal of Political Economy, University of Chicago Press, vol. 77(2), pages 245-248, March/Apr.
    2. John Makin, 1974. "Exchange rate flexibility and the demand for international reserves," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 110(2), pages 229-243, June.
    3. William J. Baumol, 1952. "The Transactions Demand for Cash: An Inventory Theoretic Approach," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 66(4), pages 545-556.
    4. Barro, Robert J, 1970. "Inflation, the Payments Period, and the Demand for Money," Journal of Political Economy, University of Chicago Press, vol. 78(6), pages 1228-1263, Nov.-Dec..
    5. Edward L. Whalen, 1966. "A Rationalization of the Precautionary Demand for Cash," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 80(2), pages 314-324.
    6. Karni, Edi, 1973. "The Transactions Demand for Cash: Incorporation of the Value of Time into the Inventory Approach," Journal of Political Economy, University of Chicago Press, vol. 81(5), pages 1216-1225, Sept.-Oct.
    7. Tsiang, S C, 1969. "The Precautionary Demand for Money: An Inventory Theoretical Analysis," Journal of Political Economy, University of Chicago Press, vol. 77(1), pages 99-117, Jan./Feb..
    8. Brunner, Karl & Meltzer, Allan H., 1978. "Public policies in open economies," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 9(1), pages 1-4, January.
    9. Fischer, Stanley, 1975. "The Demand for Index Bonds," Journal of Political Economy, University of Chicago Press, vol. 83(3), pages 509-534, June.
    10. G. C. Archibald & J. Richmond, 1971. "On the Theory of Foreign Exchange Reserve Requirements," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 38(2), pages 245-263.
    11. Frenkel, Jacob A., 1978. "Pegged exchange rates and managed float," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 9(1), pages 111-140, January.
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