Knowledge that Transforms

This paper evaluates the effects of inflationary expectations within an extended inventory model of the determination of optimal money holdings and commodity inventories. One important innovation is to introduce into the consumption bundle a commodity which is purchased less frequently than income is received. A second innovation is to consider household use of earning assets as a store of savings balances rather than working balances. The analysis shows that the effects of inflationary expectations on optimal commodity inventories and money holdings depend critically on whether the household holds part of its savings balance as earning assets. For example, if the household holds its savings balance only as money, and if the real rate of return on earning assets is constant, an increase in the expected rate of inflation would induce a reduction in total money holdings and also, somewhat surprisingly, a reduction in total commodity inventories.

The wealth effect on the individual's money demand is examined within the inventory theoretical framework involving stochastic cash needs. A positive wealth effect arises if an increase in wealth increases the individual's planned expenditure beyond his expected receipts, or if the marginal yield on earning assets is diminishing or marginal penalty cost is increasing. The direct wealth effect due to decreasing absolute risk aversion is negative rather than ambiguous as obtained by Arrow (1971). Finally, interpreting penalty cost as the utility lost due to inadequate money holding could give rise to a positive wealth effect, but the presence of near-money assets makes it negative.