Transactions and Precautionary Demand Models

Mean-variance models are most applicable to asset choice decisions where returns are truly stochastic. When applied to the study of capital-certain assets, the approach is suspect. In particular, when the variances and covariances of the rates of return are small, a mean-variance model implies that most wealth will enter the asset with the highest yield. The diversification of holdings among relatively low risk-low return assets can often only be explained in terms of transactions and liquidation costs, and many studies have considered the portfolio choice problem largely in terms of such factors. This alternative treatment of the demand for money and other assets is often termed the inventory-theoretic approach, because of its similarity to the more general analysis of the demand for inventories; it emanates from the preliminary work of Baumol (1952) and Tobin (1956) on the transactions demand for money. Although these models were developed independently, their conclusions are very similar. In each case, the demand for transactions balances arises from the non-synchronisation of income receipts and expenditures, both of which are perfectly foreseen, and the brokerage costs involved in transferring funds between non-interest-bearing money and interest-earning financial assets, which provide the alternative temporary store of value. The models are important because they attribute a role to the rate of interest in the transactions demand function, a relationship which was ignored by Keynes.