Baumol’s Inventory Approach Theory

This theory suggests that the level of inventory holding of money
depends on two factors:

the carrying cost of holding money, i.e. the interest
foregone by holding money and not bonds; and

the cost of making a transfer between money and bond
- transaction cost.

Alternatively the individual could invest a proportion of the initial
income payment in bonds and then sell the bonds when additional
money is needed for transactions. If the individual invested
his income payment in bonds at the beginning of the month,
the time profile of his money holdings will be as follows.


Money holdings at the beginning of the month is Y/2 and money
holdings are run down to zero by the midpoint of the period at a
uniform rate. Average money holding for the first half of the
period is therefore Y/4. At the mid point of the period, bonds are
sold causing money holdings to return to Y/2. This is then
spent at a uniform rate over the remaining half of the period. The
average money holding for the second half of the period is Y/4.
Thus the average money holding for the whole period is Y/4,
which is lower than Y/2 (the case where no bonds are held). The
advantage of this option is that he forgoes less interest since he is
holding less money on the average but the disadvantage is that he
has incurred some transaction costs.