A Modified Baumol Approach-Optimal Withdrawal and Holding of Cash Liquid Assets

Baumol developed an equation for the transaction demand for money. It is affected positively by cost per withdrawal and transaction value, and negatively by the interest loss from holding cash.

Our objective is to modify the Baumol equation by including another factor. The demand for money is also affected by the customer concern that holding a more available liquid asset encourages more spontaneous purchases with resulting losses in their real value. We develop a new theoretical model by adding to the original Baumol cash demand equation another demand for a deposit which has positive yield and is less liquid. Holding this deposit restrains some of the spontaneous purchases. This modified Baumol equation leads to the following new results: Customers withdraw cash more often; maintain, on average, a smaller cash balance and larger amount of less liquid assets; and reduce their spontaneous and “nonrational” purchases.