Tobin’s Portfolio Balance (Speculative) Demand for Money

References
• Ghosh and Ghosh, Macroeconomics
• Various Lecture notes
• Tobin (1958), “Liquidity Preference as Behaviour Towards Risk”, Review of
Economic Studies.
Difference between Keynes demand for money and Tobin's demand for money (the 2 point below is the answer)
Tobin Reformulation of Keynesian Speculative Demand for Money
 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. Tobin showed a mix of safe asset and risky asset are
jointly held by individuals.
 Keynesian theory fails to capture uncertainty. Keynes assumed individual holds bonds
on to his expectation with certainty. However, Tobin showed that return from risky
asset is uncertain due to variability in interest rate and capital gains.
Tobin’s speculative demand for money: The Model
Derivation of budget line
Assumptions:
1. Individual has a given amount of wealth, which is assumed to be unity for
simplicity.
2. Individual holds A1 fraction of her wealth in monetary asset (safe asset) and A2
fraction in non-monetary assets, say bonds (risky assets).
3. The monetary asset earns no return, whereas, the non-monetary asset, or bonds is a
consol or perpetuity, which yields a fixed annual coupon, denoted by Y,
indefinitely. The current market interest rate is r. The current price of bonds is P.
A1 + A2 = 1 (1)

Money Balance (0, 0)

Bonds earns return which is combination of interest rate and capital gain.
Y Y Y
Thus, P = + + ... = (2)
1 + r (1 + r ) 2
r

Expected interest gain from the console per rupee invested = r

Y Y
−
Pe − P r e r r
Expected capital gain per rupee invested= = = e − 1 = g ( say )
P Y r
r

Total expected return from the console,  B = r + g (3)

Since g can take many values corresponding to many types of bonds, thus the distribution of g
is given by the following expression

Distribution of g: g (0,  B2 ) (4)

The portfolio (money and bond) has expected return ER and variance  2 .

ER = A1  0 + A2  E (  B ) = A2 E (  B ) = A2 r (using 4)

 2 = V ( A1 ) + V ( A2 B) = 0 + A22 B2

 2 = A22 B2


A2 = (4.1)

Substitute it in ER

ER = r (5)


Individual’s Preference
Assumptions:
1. Individual derives positive utility from expected return on portfolio and risk is a
bad choice for the individual’s utility.
2. Individual is a risk-averse. This implies he will undertake higher risk only if
expected return is higher. This implies convex IC.
Equilibrium and change in interest rate

1
p O

How the lower quadrant is drawn?

From eq. (4.1), we have
  
A2 = (see fig 1 below) ; or, 1 − A1 = = A1 = 1 − (see fig 2 below)
  
The following diagram follows

Plot in (  , A2 ) plane in fig 1 and (  , A1 ) plane in fig 2:

Figure 1 Figure 2
Fliiping vertically we get

Just merge both to get the original equilibrium figure lower quadrant.

 Tobin (1958) showed that the theory of risk-avoiding behaviour can serve as a basis for
liquidity preference and for an inverse relationship between the demand for money
balances and interest rates.
 The derivation doesn’t require the assumption of inelasticity of expectations of future
interest rates, and instead uses the assumption that the expected value of capital gain
(or loss) from holding interest-bearing assets is always zero.
 At low interest rates, the expectation of capital loss may push the optimal position to
(all cash, no bonds). At high interest rates, the expectation of capital gain would
increase the observed frequency of (no cash, all bonds) positions.
 The more inflexible the agent’s expectations, the more sensitive their demand for cash
will tend to be to the changes in the interest rates.