Extensive Margins and the Demand for Money at Low Interest Rates

Abstract

We argue that relevant monetary decision for majority of U.S. households is not 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 financial technology). We show that key variable governing adoption decision is product of interest rate times total amount of assets. This implies that interest elasticityof household money demand at low interest rates can be estimated from variation in asset holdings in a cross section of households rather than historical interest rate variations. We do so with 1989 Survey of Consumer Finances. We find that (a) elasticity of money demand is very small when interest rate is small, (b) probability that a household holds any amount of interest-bearing assets is positively related to level of financial assets, and (c) cost of adopting financial technologies is negatively related to participation in a pension program. The finding that elasticity is very small for interest rates below 5 percent suggests that welfare costs of inflation are small. At interest rates of 5 percent, roughly one-half of elasticity can be attributed to Baumol-Tobin or intensive margin and half to 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 cost of inflation at low interest rates.