Suggested by W.J. Baumol (1952), this is same as the economic order quantity model of the inventory management. This model attempts to balance the income foregone on cash hold by the firm against the transaction cost of converting cash into marketable securities or vice-a-versa. This model can be presented as follows:

Assumption: The Baumol’s model assumes that the firm uses cash at an already known rate per period and that this rate of use is constant.

Holding Cost: There is always a cost of holding cash by a firm. This cost may be the opportunity cost in terms of the interest foregone on the investment of this cash.

Transaction Cost: Whenever cash is to be converted into marketable securities, or vice-a-versa, there is always a cost involved in the form of brokerage, commission etc.

This model is based on the proportion that in order to reduce the holding cost, a firm keeps the least amount of cash in hand. However, as the cash level depletes, the firm can acquire cash by selling some of its marketable securities. Each time the firm transacts in this way, it bears transaction cost, so, it will like to transact as occasionally as possible. This could be done by maintaining higher cash level involving a high holding cost. Thus, the firm has to deal with the holding cost as well as the transaction cost. The optimum cash balance is found by controlling the holding cost and transaction cost so as to minimize the total cost of holding cash.

This model is almost the same as EOQ model of the inventory management and can be presented as follows:

           C  =  √ 2FT/ r

Where  C  = Cash required each time to restore balance to minimize cash
             F = Total cash required during each year
             T  = Cost of each transaction between cash and marketable securities
             r  =  Rate of interest on marketable securities 

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