Interest and Income Elasticity of Demand for Real Balances

Economists have attempted to relate the demand for real balances to the interest and income elasticity. The responsiveness of the demand for money to these two variables is of great importance in determining the slope of the LM curve and hence the effectiveness of the monetary and fiscal policy in influencing the economy.

 The Baumol- Tobin model suggests that the income elasticity of demand for money is ½. Thus, an increase in the real income by 10% will lead to an increase in the demand for real balances by 5%. The interest elasticity of demand for money is _1/2. Thus, an increase in the interest rate by 10% will lead to a decrease in the demand for real balances. However, several empirical studies show that the income elasticity of demand for real balances is greater than ½ and the interest elasticity of demand for real balances is smaller than ½. Thus, the Baumol-Tobin model is not entirely correct. This happens because some people may have lesser freedom in exercising their discretion over their holdings of money than is assumed by the model

Thus, interest elasticity of money supply has the effect of making fiscal policy more effective. The fiscal policy makers can consider this important implication of the policy variable, namely money supply controlled by the central bank.