title: On impulse control and the demand for money
Creators: name: Sivananthan, Arujuna
Publisher: name: University of Glasgow
Year: 1997
Subjects: subject: Economic theory.

description: The Objective Money affects every aspect of life and yet its impact on a macro or micro level is not clearly understood. From an individual's point of view an efficient cash management policy could free resources for consumption which otherwise may have been wasted on either holding or transaction costs. But few models analyse a risk-averter's cash management decision and its impact on the money stock. Part of this deficiency can be attributed to the difficulties which arise from the non-linearities inherent in concave utility functions. The sheer complexity of modelling the dynamic evolution of variables which influence the cash management decision, and, the interaction between them has been another factor. The history of research into the demand for money is vast and has been an important feature in the evolution of macroeconomic theory. Numerous modelling approaches have been utilised to study the many properties of money, varying from general equilibrium analysis to micro-based models in which the agent behaves like a private optimiser. Important contributions have been made by eminent economists on how the money stock behaves. Fisher's quantity theory identity MV = PY; M is the nominal stock of money, V is the velocity of circulation, P is the price level, and Y is the volume of transactions or real income, which was developed in 1911 still features prominently in economic analysis. The velocity of circulation is assumed to be determined by an exogenous payments mechanism and therefore constant. Hence any change to the money stock yields neutral effects over the long run. Pigou (1917) changes this to include the consumer allocation problem, interest rates and wealth, which subsequently comes to form the basis of the Cambridge equation. These models set the tone for the literature which later followed from the various Classical schools arguing in favour of a passive monetary policy. Keynes in his General Theory of Employment, Interest and Money (1936) radically challenges this view by arguing that velocity was not constant, but varied with the price level and income, which, therefore, required an interventionist monetary authority. He divides the money stock into three components proposing that agents hold money for three very different reasons. The first he concludes is the transactions motive where agents hold money to satisfy planned expenditure. The second is the precautionary motive where money is held as a buffer stock to absorb any unanticipated expenditure shocks. The third is the speculative motive where agents hold money because it is an asset. At the time Keynes wrote his general theory real appreciations in the value of the nominal money stock were not uncommon. Therefore the role of money as a speculative asset was more important then, than it is now. Baumol (1952) and Tobin (1956) formalise the transactions motive by placing it within a dual asset optimisation framework. Agents in these models optimally determine their money stock by minimising the associated opportunity costs. Miller and Orr (1966) develop this further by introducing uncertainty through a discrete steady state random walk. By limiting the type of agent considered to be risk neutral, they effectively model the problem as a dual asset management exercise in which the agent optimises his utility of his wealth, similar to Tobin (1958). Constantinides and Richard (1978) model the cash management decision as a net present value problem. Increasing the time horizon reduces the frequency of transactions in which agents switch from cash to the interest earning asset or vice versa but increases their magnitude. Smith (1989) expands on this by allowing for interest rate uncertainty. A critical review of the current literature on the transactions money demand for money is presented in Chapter 3. The original objective of this thesis was to expand on Smith (1989) by developing a model that studied a risk-averter's cash management decision which included genuine aspects of risk and a discretely varying stochastic interest rate. The motive behind this was to study the impact of increased risk sensitivity on an agent's money demand function and also capture the discrete jumps which interest rates exhibit in the real world.