In Discussion Paper No. 1358, Casey Mulligan and Research Fellow Xavier Sala-i-Martin explore some of the behavioural distortions created by inflation. Using data on asset holdings of US households, as measured by the 1989 survey of consumer finances (SCF), they note that 59% of all US households do not hold any interest-bearing assets, and 53% of those who hold cheque accounts do not hold any interest-bearing assets. The question is why? The authors argue that the relevant decision for the majority of US households is not the fraction of assets to be held in interest-bearing form, but whether to hold such assets at all. They show that the key variable governing the adoption decision is the product of the interest rate and the total amount of assets. The implication is that, instead of studying the demand for money using time-series data, in particular historical interest rate variations, one can look instead at a cross-section of households and analyse variations in the amount of assets held in order to measure the demand for money.

This methodology can be used to estimate the interest elasticity of money demand at interest rates close to zero. Empirical analysis uncovers that: (i) the elasticity of money demand is very small when the interest rate is small; (ii) the probability that a household holds any amount of interest-bearing assets is positively related to the level of financial assets; and (iii) the cost of adopting financial technologies is positively related to age and negatively related to the level of education. The finding that the elasticity is very small for interest rates below 5% suggests that the welfare costs of inflation are small. It is also found that with interest rates at 6%, the elasticity is close to 0.5. Roughly one-half of this elasticity can be attributed to the Baumol-Tobin effect or intensive margin, i.e. people who use interest-bearing assets regularly switch from money to interest-bearing assets. The other half of the elasticity is attributed to the new adopters or extensive margin, i.e. people who for the first time adopt interest-bearing financial technology. The intensive margin is less important at lower interest rates and more important at higher interest rates. This suggests that a lowering of the US nominal interest rate from 5% to 1% would have a much smaller welfare gain than lowering it from 9% to 5%.

Adoption of Financial Technologies: Implications for Money Demand and Monetary Policy
Casey B Mulligan and Xavier X Sala-i-Martin