Question

analysis the impact of a decrease in the price of bond on the optimal number of transactions,money and bond holdings in inventory-theoratic approach to the transactions demand for money.

Answer 1

Inventory theory of money demand given by Baumol deals with the transctionary demand for money where money is trated as an inentory. Like how companies keep a horde of goods as invewntory, Baumol assumes that people keep money as an inventory to facilitate transactions.

The demand for such inventory depends on the opportunity cost of holdin money in hand, that is, the interest on eloses when money is kept idle instead of as saving deposits, fixed deposits or bonds.So, the demand for holding money depends on the rate of interest of the bonds.the demand for money also de-pends on the brokerage paid(service fee to the bank each tim,e you withdraw money).

When the price of bond decreases, the money demand decreases as the individual can buy bond and earn an interest from it. This reduces the inventory demand for money. The optimal number of transactionary demand for money reduces. the people now prefer to have hold bonds instead of holding them as money. The main objective of the people is to go for a cost minimising decision. In the case of reduction in bond price, the people are not wiling to sacrifice the cost by holding money. hence, they resort to buying bonds.

Apart from the rate of interest, Income of the individual also plays a major role in deciding the trade off between money and bonds.The higher the income, given the interest rate, transctionary demand for money is higher.