A THEORETICAL EXPLANATION OF THE INTEREST INELASTICITY OF MONEY DEMAND.

W.J. Baumol and J. Tobin applied the principle of profit maximization to the management of money balances. Under fairly restrictive assumptions they obtained the conclusion that the income elasticity of the transactions demand for money should be plus one half and the interest elasticity minus one half. The hypothesis is not directly testable because estimates of the transactions demand for money are not available. However, tests using the total demand for money do not support the Baumol-Tobin (BT) elasticities. Authors show that if profit maximization is assumed and more general assumptions employed the only restriction is that the interest elasticity of the total demand for money is between zero and minus one. This finding offers theoretical justification for many previously published statistical results. A very primitive theory of the demand for money may be obtained by assuming that income is distributed at the beginning of each month and that the individual spends it (all) evenly in the course of the month. The only money he holds is the as yet unspent balance. This model implies that the demand for money is proportionate to income. BT regarded their approach as being relevant only to the transactions demand for money.