Discussion Paper Details

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Title: Financial Innovation and the Transactions Demand for Cash

Author(s): Fernando Alvarez and Francesco Lippi

Publication Date: September 2007

Keyword(s): inventory models, money demand and technological progress

Programme Area(s): International Macroeconomics

Abstract: We extend the Baumol-Tobin cash inventory model to a dynamic environment, which allows for the possibility of withdrawing cash at random times at a low cost. This modification captures developments in withdrawal technology, such as the increasing diffusion of bank branches and ATM terminals. We document cash management patterns for households that are at odds with the predictions of deterministic inventory models that abstract from precautionary motives. We characterize the solution of the model and show that qualitatively it is able to reproduce such patterns. Estimating the structural parameters we show that the model accounts for key features of the data. The estimates are used to quantify the expenditure and interest rate elasticity of money demand, the impact of financial innovation on money demand, the welfare cost of inflation, the gains of disinflation and the benefit of ATM ownership.

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Bibliographic Reference

Alvarez, F and Lippi, F. 2007. 'Financial Innovation and the Transactions Demand for Cash'. London, Centre for Economic Policy Research.