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BAUMOL Economic Model
BAUMOL Economic Model
INTRODUCTION
William J. Baumol developed a model(The
transactions Demand for Cash: An Inventory Theoretic
Approach) which is usually used in Inventory
management & cash management.
It trade off between opportunity cost or carrying cost
or holding cost & the transaction cost.
As such firm attempts to minimize the sum of the
holding cash & the cost of converting marketable
securities to cash.
ASSUMPTIONS
The firm is able to forecast the cash needs
with certainty.
The firms cash payments occurs uniformly
over a period of time.
The opportunity cost of holding the cash is
known & it does not change over time.
The firm will incur the same transaction cost
whenever it converts securities to cash.
When the cash inflow is received invest one half of the total inflow:
put the remaining one half in the disbursment account.
2.
During the first half of the period, pay disbursments from the
disbursment account. This account will be drained one half of the way
through the period. At that time sell the investments & pay
disbursment account
3.
Use these funds to pay disbursments during the remainder of the
period.
Thus ,
Investment Income= (1/2)(1/2)iY=(1/4)iY
Here, Y be the amount of cash inflow & i be the interest rate per
period
Profit=(1/4)iY-2a
Here, a is the cost per transaction
Strategy
Interest Income = (2/3)(1/3)iY+(1/3)(1/3)iY= (1/3)iY\
Profit = (1/3)iY-3a
In general;
Interest Income = [(n-1)/2n]iY
Profit = [(n-1)/2n]iY-na.
Where n is the no. of transactions, a is the cost per transaction