The Demand for Cash by Corporations

Abstract

The interest in the study of behaviour of the transactions demand for cash by corporations has been stimulated by Baumol (1952), Tobin (1956), and Friedman (1959). Baumol and Tobin suggested that there are economies of scale in cash holdings and transactions elasticity of cash balances is 0.5. Friedman’s results showed a permanent income elasticity of 1.8. The other later studies on demand for cash by firms either supported Baumol and Tobin or Friedman. Among others, Frazer (1964), Nadiri (1969), and Coates (1976) supported Baumol and Tobin while Meltzer (1963 June, 1963 August), Whalen (1965), De Allessi (1966), and Vogel and Maddala (1967) supported Friedman. Those who supported Baumol and Tobin found that under moderately restrictive assumptions optimal transactions cash balances very less than in proportion to sales and those who supported Friedman found that the elasticity of cash with respect to sales is about or more than unity.There is also no unanimous finding as regards to the effect of interest rate on demand for cash. Among others, Selden (1961), De Allessi, Nadiri, and Coates showed the statistically significant negative relationship between interest rates and demand for cash while Friedman did not find the same. It all shows that there is no unanimous finding with respect to the economies of scale in cash holdings, and the interest cost effect on demand for cash. In order to validate one view or the other, no study has so far been conducted in the context of Nepal. This paper therefore tests out the models that will either support or reject the Baumol-Tobin hypothesis.Section I of this paper describes the models that attempt to explain firm’s demand for cash and the nature and sources of data used in the statistical analysis. The regression results are presented and interpreted in Section II. Finally, the empirical findings are summarised and the conclusions are indicated in Section III.The major conclusion indicated by this paper is the empirical evidence in support of the presence of the economies of scale in cash holdings, significant effect of interest cost on investment in cash, and the slow speed of adjustment between actual and desired level of cash.