Baumol’s Inventory Approach to Transactions Demand for Money –
Baumol put forward a new approach to demand for money which explains the transaction demand for money from the viewpoint of the inventory management. Baumol asserts that individuals hold money (inventory of money) for the transaction purposes.
According to him, individuals have to keep optimum inventory of money for their day to day transaction purposes. They also incur cost when they hold inventories of money and the cost forgone is the interest rate which they could have earned if they had kept their wealth in saving deposits or fixed deposits or invested in bonds or shares. This forgone cost is also called opportunity cost.
Money that people hold in form of currency and demand deposits which are very safe and riskless but pays no interest. While bonds or shares provides returns (interest) but are risky and may also involve capital loss if people invest in them.
But saving deposits in banks are quite safe and riskfree but also gives some interest. So, Baumol questions why peoples hold money in form of currency or cash or demand deposits instead of saving deposits which are quite safe and riskfree and also earns some interest as well.
According to him, it is for convenience and capability of it being easily used for transactions purposes.
Baumol and Tobin proclaims that transactions demand for money depends on the rate of interest.
As interest rate on savings deposits goes up people will hold less money in form of currency or cash or demand deposits and vice versa.
So, individuals compare the costs and benefits of funds in the form of money with no interest with the money in the form of savings deposits with some interest.
According to Baumol, the cost forgone when people hold money is the opportunity cost of these funds.
Baumol has proved that the average amount of cash withdrawal which minimizes cost is given by –
C = √2bY/r
This means that average amount of cash withdrawal which minimize cost is the square root of the two times broker’s fee multiplied by the size of individual’s income and divided by the interest rate. This is also called Square Root Rule.