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Question - Suppose you are the financial controller of Newfundlend Company Ltd. Your company has a demand deposit account at the Memorial Bank. Further suppose the interest rate on bonds is 10% p.a. and there is a brokerage fee ofS2 per transfer between demand deposits and bonds. The revenue of your company is $10 million per year.
(a) What is the optimal holding of demand deposits according to Baumol's square-root rule? Find also the number of transfers made over the year.
(b) Prove formally that the income elasticity of money demand in Baumol's model is ½. Interpret this result in terms of economics.
(c) Suppose the revenue of your company increases by 50%, what is the increase in the optimal demand deposit balance?
(d) What is the interest elasticity of money demand according to Baumol's model?
(e) Suppose, as a result of financial innovations, the Memorial Bank is able to offer a new demand deposit account that pays interest at 2% pa but allow you to write checks at the same time. How would you expect your answers in (a) and (c) above to change? If so, calculate the changes and explain why.
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