Extensive Margins and the Demand for Money at Low Interest Rates

31 Pages Posted: 31 Oct 2000

See all articles by Casey B. Mulligan

Casey B. Mulligan

University of Chicago; National Bureau of Economic Research (NBER)

Xavier Sala-i-Martin

Columbia University, Graduate School of Arts and Sciences, Department of Economics

Abstract

We argue that the relevant monetary decision for the majority of U.S. households is not the fraction of assets to be held in interest-bearing form, but whether to hold any such assets at all (we call this "the decision to adopt" the financial technology). We show that the key variable governing the adoption decision is the product of the interest rate times the total amount of assets. This implies that the interest elasticityof household money demand at low interest rates can be estimated from the variation in asset holdings in a cross section of households rather than historical interest rate variations. We do so with the 1989 Survey of Consumer Finances. We find that (a) the elasticity of money demand is very small when the interest rate is small, (b) the probability that a household holds any amount of interest-bearing assets is positively related to the level of financial assets, and (c) the cost of adopting financial technologies is negatively related to participation in a pension program. The finding that the elasticity is very small for interest rates below 5 percent suggests that the welfare costs of inflation are small. At interest rates of 5 percent, roughly one-half of the elasticity can be attributed to the Baumol-Tobin or intensive margin and half to the new adopters or extensive margin. The intensive margin is less important at lower interest rates and more important at higher interest rates. Finally, we argue that ignoring extensive margins may lead to an empirically important over estimation of the cost of inflation at low interest rates.

Suggested Citation

Mulligan, Casey B. and Sala-i-Martin, Francesc Xavier, Extensive Margins and the Demand for Money at Low Interest Rates. Available at SSRN: https://ssrn.com/abstract=241058 or http://dx.doi.org/10.2139/ssrn.241058

Casey B. Mulligan (Contact Author)

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Francesc Xavier Sala-i-Martin

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