Question

 

1. At the beginning of the month, the household deposits $3,000 in its checking account and the other $6,000 in a bond fund. Assume the bond fund pays 3% interest per month. After 10 days, the money in the checking account is exhausted, and the household withdraws another $3,000 from the bond fund for the next 10 days. On the 20th day, the final $3,000 from the bond fund goes into the checking account.

Which approach should the household use?

1-      If the transfer expense is $230.

2-      If the transfer expense is $400

Answer 1

The bond fund strategy generates some sort of interest income. The household has $3,000 in the fund for 10 days (1/3 of a month) and $,000 for 20 days (2/3 of a month). With a rate of interest @ 3% per month, the household earns $90 in interest each month ([$3,000 × 0.03 × 1/3] + [$3,000 × 0.03 × 2/3]). The disadvantage of the bond fund strategy, is that it requires more attention—$3,000 must be transferred from the fund twice each month which also be charge fees on the transfers.

Of course, the bond fund approach ,the household could begin each month with $4,500 in the checking account and $4,500 in the funds, transferring $4,500 to the checking account in the mid of the month. This way will require one less transfer than before, but it also generates less interest—$67.50 (= $4,500 × 0.03 × 1/2). With this approach, the household demands a quantity of money of $2250. The household can also keep much smaller average quantity of money in its checking account and keep maximum in its bond fund which he could.We can prefe any other strategy also, through which there are less formalities and charges in transfers as it charges as much we might get in interest if amounts are smaller.

Which approach must the household use?

That is a decision each household should make—it is a question of weighing the interest a bond fund strategy creates against the obstacles and possible fees associated with the transfers it requires.

First, a household should go for a bond fund approach when the interest rate are higher. At low interest rates, a household does not invest much of its income by pursuing the simpler cash strategy. As the interest rate shoots up, a bond fund strategy seems more attractive. That means that the higher the interest rate, the lower the quantity of money demanded as it yields high interest and try to avoid transfer fees.

Second, people try to use a bond fund strategy when the cost of transferring funds is lower.

For example at transfer cost of $230 we can might think of two transfer but at $400 we can go for one transfer as maximum transfer will not only eat up interst that we earn but also the principal amount invested.