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Financial Innovation and the Transactions Demand for Cash

Fernando Alvarez
Francesco Lippi

Abstract

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, which qualitatively reproduces several empirical patterns. We estimate the structural parameters using micro data and show that quantitatively the model captures important economic patterns. 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, and the benefit of ATM ownership.