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Extensive Margins and the Demand for Money at Low Interest Rates

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  • Casey B. Mulligan
  • Xavier Sala-i-Martin

Abstract

We argue that the relevant monetary decision for the majority of U.S. households is not the fraction of assets to be held in interest-bearing form, but whether to hold any such assets at all (we call this "the decision to adopt" the financial technology). We show that the key variable governing the adoption decision is the product of the interest rate times the total amount of assets. This implies that the interest elasticity of household money demand at low interest rates can be estimated from the variation in asset holdings in a cross section of households rather than historical interest rate variations. We do so with the 1989 Survey of Consumer Finances. We find that (a) the elasticity of money demand is very small when the interest rate is small, (b) the probability that a household holds any amount of interest-bearing assets is positively related to the level of financial assets, and (c) the cost of adopting financial technologies is negatively related to participation in a pension program. At interest rates of 5 percent, roughly one-half of the elasticity can be attributed to the Allais-Baumol-Tobin or intensive margin and half to the new adopters or extensive margin. The intensive margin is less important at lower interest rates and more important at higher interest rates. Finally, we argue that ignoring extensive margins may lead to an empirically important overestimation of the cost of inflation at low interest rates.

Suggested Citation

  • Casey B. Mulligan & Xavier Sala-i-Martin, 2000. "Extensive Margins and the Demand for Money at Low Interest Rates," Journal of Political Economy, University of Chicago Press, vol. 108(5), pages 961-991, October.
  • Handle: RePEc:ucp:jpolec:v:108:y:2000:i:5:p:961-991
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    References listed on IDEAS

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    1. Kimbrough, Kent P., 1986. "The optimum quantity of money rule in the theory of public finance," Journal of Monetary Economics, Elsevier, vol. 18(3), pages 277-284, November.
    2. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
    3. 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..
    4. Gillman, Max, 1993. "The welfare cost of inflation in a cash-in-advance economy with costly credit," Journal of Monetary Economics, Elsevier, vol. 31(1), pages 97-115, February.
    5. Lucas, Robert E, Jr & Stokey, Nancy L, 1987. "Money and Interest in a Cash-in-Advance Economy," Econometrica, Econometric Society, vol. 55(3), pages 491-513, May.
    6. R. S. Uhler & J. G. Cragg, 1971. "The Structure of the Asset Portfolios of Households," Review of Economic Studies, Oxford University Press, vol. 38(3), pages 341-357.
    7. Casey B. Mulligan & Xavier Sala-i-Martin, 1995. "Adoption of financial technologies: Implications for money demand and monetary policy," Economics Working Papers 134, Department of Economics and Business, Universitat Pompeu Fabra.
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