In the Baumol-Tobin inventory approach to transactions demand for money, an increase in the interest rate will:

Correct answer: D) Reduce the average money balance held for transactions

Explanation

Baumol and Tobin showed that the optimal average cash balance is proportional to the square root of (2bY / r), where b is the brokerage cost and r the interest rate. A higher r raises the opportunity cost of holding cash, so people hold less money and make more frequent conversions. Thus even transactions demand is interest-sensitive, contrary to the simple Keynesian view.