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Tobin's Portfolio Approach To Demand For Money

Tobin's portfolio approach to demand for money suggests that individuals hold both money and bonds as part of an optimal portfolio, rather than all of one or the other. It recognizes that money offers safe returns while bonds carry risk, so investors balance risk and return by allocating their wealth across both. The demand for money then depends on expected returns on stocks, bonds, and inflation, as well as overall real wealth, as these factors influence how much an individual allocates to money versus other assets in their portfolio. Tobin's model provides an improvement over Keynes' theory by allowing for simultaneous holding of money and bonds rather than all of one.

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Kushagra Pratap Singh
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1K views15 pages

Tobin's Portfolio Approach To Demand For Money

Tobin's portfolio approach to demand for money suggests that individuals hold both money and bonds as part of an optimal portfolio, rather than all of one or the other. It recognizes that money offers safe returns while bonds carry risk, so investors balance risk and return by allocating their wealth across both. The demand for money then depends on expected returns on stocks, bonds, and inflation, as well as overall real wealth, as these factors influence how much an individual allocates to money versus other assets in their portfolio. Tobin's model provides an improvement over Keynes' theory by allowing for simultaneous holding of money and bonds rather than all of one.

Uploaded by

Kushagra Pratap Singh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Tobin’s Portfolio

Approach to
Demand For Money
INTRODUCTION
The main problem with Keynesian approach to the demand for money is that it suggests that individuals should, at
any given time, hold all their liquid assets either in money or in bonds, but not some of each.

This is obviously not true in reality.

he second approach — Tobin’s model of liquidity preference — deals with this problem by showing that if the
return on bonds is uncertain, that is, bonds are risky, then the investor worrying about both risk and return is likely
to do best by holding both bonds and money.

Portfolio theories like the one presented by Tobin emphasises the role of money as a store of value. According to
these theories, people hold money as part of their portfolio of assets. The reason for this is that money offers a
different combination of risk and return than other assets which are less liquid than money — such as bonds.
To be more specific, money offers a safe (nominal) return, whereas the prices of stocks and bonds may rise or fall.
Thus Tobin has suggested that households choose to hold money as part of their optimal portfolio.

Portfolio theories predict that the demand for money depends on the risk and return associated with money holding
as also on various other assets households can hold instead

of money. Furthermore, the demand for money should depend on real wealth, because wealth measures the size of
the portfolio to be allocated among money and the alternative assets.
For instance, the money demand function may be expressed as:

(M/P)d = f(rs, rb, πe, W)

where rs = the expected real return on stock, rb = the expected real return on bonds, πe = the expected inflation rate
and W= real wealth. An increase in rs or rb reduces money demand, because other assets become more attractive.
An increase in ne also reduces money demand, because money becomes less attractive. An increase in W raises
money demand, because higher wealth means a larger portfolio.

It is against this backdrop that we study the portfolio theory of money demand.
Tobin’s Portfolio Approach to Demand For Money

BONDS MONEY AS ASSET


Tobin’s Portfolio Approach to Demand For Money

PORTFOLI
O

BONDS MONEY AS ASSET


● High average return ● Comparatively low average
● Higher degree of risk return
● No risk
Tobin’s Liquidity Preference Function

Tobin’s Liquidity Preference Function depicts the


relationship between rate of interest and demand for
money

As rate of interest
Asset Demand for
Money
Tobin’s Liquidity Preference Function
An Improvement on Keynes theory of Liquidity preference

Keynes:- Individuals hold all their wealth in either all


money or all bonds

Tobins:- Individuals simultaneously hold all their wealth


in either bonds or money
An Improvement on Keynes theory of Liquidity preference

Keynes:- Demand for money for transaction purposes


is insensitive to interest rate

Tobin:- He has showed us that money held for


transaction purposes is interest elastic
Tobin’s Liquidity Preference Function
TOBIN’S PORTFOLIO BALANCE APPROACH

MONEY BONDS

IT OFFERS the return on bonds is


SAFE uncertain, that is,
RETURN bonds are risky
TOBIN’S PORTFOLIO BALANCE APPROACH

rs = the expected real return on stock


rb = the expected real return on bonds
πe = the expected inflation rate
W= real wealth.
THANK YOU

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