RESTRICTIONS ON THE RATE OF INTEREST ON DEMAND DEPOSITS AND A THEORY OF COMPENSATING BALANCES.

This paper explores and extends the theory of the demand for money by firms. Existing models fail to explain the high levels of deposits held by firms. Such large balances are usually explained by the existence of compensating balance arrangements in this country. However, the traditional theory of compensating balances views the practice as irrational if it results in an increase in firms' balances. The paper presents a transactions demand theory of firms' demand for money. It is demonstrated that compensating balance arrangements are a rational response to the prohibition on the payment of interest on demand deposits in this country. With compensating balances the firm and the bank, taken together, are better off than in the absence of such practices. The savings in transaction cost to the firm resulting from increased balances is greater than the opportunity cost of the additional reserves which the bank must hold. Furthermore, optimal balance requirements result in optimal money demand identical to that in a system with no restriction on the deposit rate. Thus, the same result is achieved by paying an optimal cash deposit rate and an optimal implicit deposit rate through services. Although the framework developed applies to compensating balance requirements on loans, only compensating balances held in payment for services is analyzed in this paper. The impact of optimal requirements can be incorporated easily in the tradition transactions money demand models. This modification would be expected to improve significantly these models' predictions of firms' money demand. The paper concludes with a discussion of the implication of this analysis for macroeconomic analysis and for the regulation of interest rates on demand deposits. It is demonstrated that optimal compensating balance requirements subvert the objective of this regulation. [ABSTRACT FROM AUTHOR]