What Is the Opportunity Cost of Holding Money?

In monetary theory, interest rates are considered an important factor. At the same time, different bonds of different substitutes of currency have different risks, so interest rates and risks have become important factors for people's demand for money. Therefore, many economists explain the three motivations for holding money in Keynes's theory by developing more precise theories. The Bowmore-Tobin model and the Tobin mean-variance model are introduced below.

Bowmore's Law

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In monetary theory, interest rates are considered an important factor. At the same time, different bonds of different substitutes of currency have different risks, so interest rates and risks have become important factors for people's demand for money. Therefore, many economists explain the three motivations for holding money in Keynes's theory by developing more precise theories. The Bowmore-Tobin model and the Tobin mean-variance model are introduced below.

Chinese name

Bowmore's Law

Theory

Money theory

Features

Interest rates are considered an important factor.

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People have the opportunity cost of holding money

The Baumol-Tobin model study concludes that money demand at the transaction demand level is sensitive to interest rates. The basic idea of this model is that people have the opportunity cost of holding money, that is, the interest income of the currency's substitute asset bonds. The advantage of holding currency is to avoid transaction costs, and holding bonds has transaction costs. People can frequently exchange currencies and bonds during the time period in which they deal with daily transactions, as long as interest income exceeds transaction costs. When interest rates rise, the opportunity cost of holding money must increase. As long as the opportunity cost of holding currency is greater than the transaction cost of holding bonds within the time that does not affect daily transactions, people are willing to give up part of the currency and hold bonds in order to seek benefits. vice versa. It can be seen that transaction demand is also sensitive to currency, that is, transaction demand is negatively correlated with interest rate levels.

Similarly, the cautious motivation that can be obtained along the Baumol-Tobin model is also negatively related to interest rate levels. The mathematical expression of Bowmore-Tobin model is:

MD = B * T0 / 2i square root

Always MD means the amount of cash you are willing to hold, T0 is the individual income at the beginning of each period, b is the transaction cost of the bond, and i is the bond interest rate. This model is also called the square root rule. For money demand, it means:

Increase in income T0 and increase in money demand;

The increase in transaction costs b will result in a decrease in demand for bonds and an increase in demand for money;

The increase in bond interest rate i will increase the demand for bonds

The change in price causes b and T0 to change at the same time, resulting in a change in MD in the same proportion.

The Tobin mean-variance model is the development of Tobin's theory of Keynes' speculative demand. In Keynes's theoretical model of speculative demand, the only substitute asset for money is bonds. Whether people hold bonds or currencies depends on the bond's interest rate. When the expected return on bonds is greater than the expected return on money, people will hold bonds and demand for money will fall. vice versa. But Keynes ignored the possibility of people holding diversified bonds and currencies, and using assets such as money to store wealth. Tobin believes that bond prices are volatile and risky. Whether people hold money or bonds not only consider the interest rate of the bond, but also the risk of the bond. The magnitude of risk is inversely related to the number of bonds held. So the way people store wealth is to diversify their assets, to hold money and bonds at the same time, to avoid the risk of putting all their eggs in one basket.

The practical economic significance of the Bowmore-Tobin model is that interest rates have an important impact on people's trading needs and prudent needs. Combining the reality of China's financial system reform, we can appreciate the significance of interest rate liberalization and the diversification of financial instruments. Theoretically, the marketization of interest rates is conducive to absorbing the transaction demand of residents and the prudent demand for the amount of money. Residents invest in enterprises based on changes in the level of marketization of interest rates, on the one hand, to solve corporate financing problems, and on the other hand, to increase residents. Income is conducive to expanding effective demand. At the same time, the diversification of financial instruments is conducive to the diversification of investment channels, directing the money in the hands of residents into the field of production and circulation, expanding production, increasing employment, increasing residents' income, and promoting a virtuous cycle of the economy.

The significance of Tobin's mean-variance model is that residents' investment needs are affected by both interest rates and risks. Interest rates and risks always go hand in hand in a market economy, which means that risks always exist in a market economy. But how to weaken the risk and solve the adverse selection and moral hazard caused by the asymmetry of information in the financial market requires corresponding laws and regulations to enable investors to obtain and accept as much information as possible from investors and minimize the problem of information asymmetry. To motivate residents to invest. In connection with the repeated blows to shareholders in China's stock market, the asymmetry of information has not been a profound lesson for the development of China's stock market.