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On Transactions and Precautionary Demand for Money

  • Frenkel, Jacob A
  • Jovanovic, Boyan

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.

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Article provided by MIT Press in its journal Quarterly Journal of Economics.

Volume (Year): 95 (1980)
Issue (Month): 1 (August)
Pages: 25-43

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Handle: RePEc:tpr:qjecon:v:95:y:1980:i:1:p:25-43
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  1. Archibald, G C & Richmond, J, 1971. "On the Theory of Foreign Exchange Reserve Requirements," Review of Economic Studies, Wiley Blackwell, vol. 38(114), pages 245-63, April.
  2. John Makin, 1974. "Exchange rate flexibility and the demand for international reserves," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 110(2), pages 229-243, June.
  3. Fischer, Stanley, 1975. "The Demand for Index Bonds," Journal of Political Economy, University of Chicago Press, vol. 83(3), pages 509-34, June.
  4. Barro, Robert J., 1970. "Inflation, the Payments Period, and the Demand for Money," Scholarly Articles 3451392, Harvard University Department of Economics.
  5. 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..
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