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The
Review
VOLUME XXXVIII
of
Economics
and
Statistics
AUGUST I956
NUMBER
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242
transactions balances and the cost of his transactions. When the yield disadavantage of cash
is slight, the costs of frequent transactions will
deter the holding of other assets, and average
cash holdings will be large. However, when the
yield disadvantage of cash is great, it is worth
while to incur large transactions costs and keep
average cash holdings low. Thus, it seems
plausible that the share of cash in transactions
balances will be related inversely to the interest
Lrate on other assets. The remainder of the
paper is a more rigorous proof of this possibility.
Let bonds represent the alternative asset in
which transactions balances might be held.
Bonds and cash are the same except in two respects. One difference is that bonds are not a
medium of payment. The other is that bonds
bear an interest rate.3 There is no risk of default on bonds, nor any risk of a change in the
rate of interest.
A transaction of $x, either way, between
bonds and cash is assumed to cost $(a + bx),
where a and b are both positive. Part of the
cost of a transaction is independent of the size
of the transaction, and part is proportional to
that amount.
At the first of each time period (t = o), the
individual receives $Y. He disburses this at a
uniform rate throughout the period, and at the
end of the period (t = i) he has disbursed it
all.4 Thus his total transactions balance, what-
I)
(I)
t)dt = Y/2.
(2)
B (t)dt
C =fJe C(t)dt
B+ C=T=Y/2.
(4)
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243
Chart i presents two possible ways of scheduling two transactions. The first way, shown in
Chart ia, is to hold all cash, no bonds, until
time t1; to buy B1 bonds at that time; to hold
these, and earn interest on them, until time t2;
and then to convert them into cash. Total interest earnings are proportional to the shaded
area. The second way, shown in Chart ib, is
to buy the same amount of bonds B1 immediately on receipt of periodic income Y, and to
SCHEDULING OF Two
TRANSACTIONS
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244
hold them until they absolutely must be sold schedule. In general, for n transactions, the
in orderto get the cash necessary for subsequent optimal schedule is to buy at time zero
payments. The revenue from this schedule is n i
Y bonds, and to sell them in equal inproportional to the shaded area in Chart ib,
n
and is obviously greater than the revenue in stallments of Y/n at times t2 = i/n, t3
Chart ia. The two general principles exempli~n - I
t - I
~nn
The
.--tn=
fied in the superiority of the second schedule to 2/n, . . . tj
the first are as follows:
average bond holding, following this schedule,
(a) All conversion from cash into bonds is half of the initial holding:
should occur at time o. Whatever the size
n-I
B
of a transaction in this direction, to postpone
2n
it is only to lose interest.
(b) A transaction from bonds into cash Revenue is rB", or:
should not occur until the cash balance is
n- I
(6)
(n2)
Yr.
Rn=
zero. To make this transaction before it is
2n
necessary only loses interest that would be
earned by holding bonds a longer time.
Transaction costs are equal to na, so that net
revenue is:
There are many schedules of two transactions that conform to these principles. Two
(n 2)
Yr-na
(7)
rn=
possibilities are shown in Chart 2. In Chart 2a
2n
the initial transaction is obviously too great,
and the second transaction must therefore be where a is the cost of a transaction. These retoo early. The optimal schedule is to convert sults are all proved in the Appendix.
Some modificationin the argument is needed
half of Y into bonds at time o and to sell them
to take account of transaction costs proporfor cash at time '2.5
If three transactions are allowed, it is not tional to the size of the transaction. If this cost
necessary to sell all the bonds at one time. Some is b per dollar, then every dollar of cash-bondsmay be sold at time t2 and the remainder at cash round trip costs 2b, no matter how quickly
time t3. This makes it possible to buy more it is made. The interest revenue from such a cirbonds initially. Chart 3 shows the optimal cuit depends, on the other hand, on how long
the dollar stays in bonds. This means that it is
TRANSACTIONS
THREE
OF
SCHEDULING
CHART 3.worth while to buy bonds only if they can be
held long enough so that the interest earnings
exceed 2b. This will be possible at all only if r
exceeds 2b, since the maximum time available
is i. The minimum time for which all bonds
purchased at time zero must be held, in order
to break even, is 2b/r. Holding bonds beyond
that time, so far as transactions needs permit,
will result in interest earnings which are clear
gain. The problem is the same as in the simpler
case without size-of-transaction costs, except
that the effective beginning time is not t1 = o
but t1 = 2b/r, and consequently the effective
beginningtotal transactionsbalance is not Y but
b/r) ]. With these modifications, the
Y[I -(2
solution for the optimal scheduling of n transactions is the same: Put (n - i)/n of the be' For /2 is the value of t2 which maximizes the expresginning balance into bonds, and sell these bonds
sion representinginterest revenue: rY(i - t2) t2.
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4. -
SCHEDULING OF TRANSACTIONS
of n, which
approaches 2
245
Yr (
I _-
as n
Rn
_2b
r
I)
II
(r :-2b) (I
Total cost, na, is simply proportionalto a; and
marginalcost is a constant.
There are four possible kinds of solution n *,
of which Chart 5 illustrates only one. These are
defined by the relation of the interest rate to
volume and costs of transactions, as follows:
-RYr2n(n+
(n :-2),
I. a > '8 Yr
7*
I--)
is
negative.
wr0is
equal to zero.
II. a = '8 Yr( I
7)
iS
zero. In
Bit
4b2A
2 ),
(n_-
V-r
(r > 2b)
(8)
Yr
(I
n -I
2n
Yr
b(n
:-2)
r
2b 2
2n
7Tn =
Yr
* = 2.
I _
Here
> a >-
)
7,T
Yr(
is positive for n
2b
2
);
but
5/6.
'8
i--
(n :-2 ), (r
(r :-2b)
(9)
) -na.
2b)
(IO0)
IV..
I/I2
Yr (
a. The optimal
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2A6
CHART 5. -
6. -
CHART
APPENDIX
I. Suppose that (I - t2)Y bonds are bought at
time t = o and held until t = t2. From t2 until t3,
bonds are held. In general, from t1-1
(I - t3)Y
until ti, (i - ti) Y bonds are held, and finally from
t.-1 until t., (i - tn) Y bonds are held. After t1,n
bond holdings are zero. Every dollar of bonds held
from ti-. until ti earns interest in amount (t t_i)r. Since the total sales of bonds are the same
(II-t2
Y* t2r+(I
I-t3)
' (t-t2)r+
*h
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...
247
Bn =
Rnas follows:
YX ( I-t,)
i=2
Y(I-tl)2(n-i)
Bn
t-t
1)
(A2)
Y(n-i)
t2-2t3+t4
t3-2t4+t5
o
o
(A3)
= 0
tn-2-2tn-l+tn
tn-1-2
tn
t3
ti
= t, +-
(I-
tq = ti +
tl )
(A4 )
(I-t1
n
I
n -
n-i+i
n
I~~~~~~
(i=2,3,.
(I-t1).
Rn= Yr
3, ..
(=2
(A2)
.n)
.n)
(As)
(A6)
gives:
n~
(_-tl)2
(n-i+
Yr
(-1)
n2
2b
-
I)
n(n-(
26
(A8)
= _4
-2t2+t3
2fl
Substituting -
2f
(I-tl)2
Bn
=
The ti(i = 2, ... n) are to be chosen so as to maximize Rn. Setting the partial derivatives equal to
zero gives the following set of equations.
t1
(n-i)
2Ytl(I-tl)
+
2f
Y. ( I -ti)(t
Rn = Y{r j=2
t2 = ti
) +Yr(I-t2)
(ht-ti_1
(A7)
r
in the text is easily derived. Equation (6) in the
text is a special case of (9).
B., average bond holding, is obtained from the
definition (4) as follows:
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