Question

Compare the cost minimization and the profit maximization approaches to the derivation of the transactions demand for money. What insights do we get for the transactions money demand from using the profit maximization approach that are not apparent from the cost minimization approach?

Answer 1

The cost minimization approach of the transaction demand for money is explained by the Baumol Inventory Approach and the profit maximization approach of the transaction demand for money is explained by Tobin's Liquidity Preference theory.

Explanation:

The cost minimization is a concept in which the cost of production is minimized to increase the profits. It tries to achieve the cost-effective outcome. The profit maximization approach is related to maximizing the profits by equating marginal cost and marginal revenue. Here, the optimal level is defined to maximize the profits. Transaction demand for money (Md) is the demand for money for transaction purposes, that is, money demand to carry out daily activities.

We will understand the comparison between cost minimization approach and Md through Baumol Inventory Approach. According to him, people keep optimal inventory of cash for the transaction purposes and also, they incur a cost because of a preference to hold money. This cost is the opportunity cost because of the interest rate forgone. The preference to hold money instead of saving it at some interest rate is the cost incurred by the wealth holders. The wealth holders will want to minimize their cost and will prefer to invest or save money in the banks to minimize their costs, but also they will keep some liquidity to meet the daily requirements.

The comparison between maximization of profits and Md will be understood by Tobin's Liquidity Preference theory (TLP). In this theory, Tobin showed the relationship between Md and rate of interest. According to him, if interest rates are increased, then demand for bonds will increase and people will choose to hold their wealth in bonds instead of cash. The higher the interest rates, the lower will be the Md. This will maximize the profits as people will earn interest on their wealth.

The insight from the profit maximization approach is that the wealth holders will prefer to invest in bonds when interest rates rise. This theory tells us about the liquidity preference in the society. Also, people prefer to invest in risk-bearing assets instead of saving deposits (SDs) which are free from risks. This is because risk-bearing assets can be easily used for transactional purposes unlike SDs.