NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Financial Innovation and the Transactions Demand for Cash

Fernando E. Alvarez, Francesco Lippi

NBER Working Paper No. 13416
Issued in September 2007
NBER Program(s):   EFG   ME

We document cash management patterns for households that are at odds with the predictions of deterministic inventory models that abstract from precautionary motives. We extend the Baumol-Tobin cash inventory model to a dynamic environment that allows for the possibility of withdrawing cash at random times at a low cost. This modification introduces a precautionary motive for holding cash and naturally captures developments in withdrawal technology, such as the increasing diffusion of bank branches and ATM terminals. We characterize the solution of the model and show that qualitatively it is able to reproduce the empirical patterns. Estimating the structural parameters we show that the model quantitatively 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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An online appendix is available for this publication.

This paper was revised on May 12, 2008

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Published: Fernando Alvarez & Francesco Lippi, 2009. "Financial Innovation and the Transactions Demand for Cash," Econometrica, Econometric Society, vol. 77(2), pages 363-402, 03.

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