In the Baumol-Tobin model, given that total costs for an individual equals + , where T0 = monthly income, b = brokerage costs, and C = amount raised from each bond transaction, derive the so-called square root rule
What will be an ideal response?
An individual will minimize their costs. Thus, the optimal level of C is found as follows:
COSTS = +
= + = 0
=
Since money demand is the average desired holdings of cash balances, C/2:
Md = =
The last expression is the square root rule.
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