TOBIN’S PORTFOLIO

BALANCE APPROACH
POST KEYNESIAN DEMAND THEORY
�Keynes speculative demand based on uncertainty.
Individuals sure in their minds wrt the movement of
rate of interest and hence put all their speculative
balances either in cash or in bonds
�Tobin in his theory states that individuals hold a
combination of cash and bonds and hold diversified
portfolio. His theoretical analysis tries to show how
people’s desire to hold money may be derived from
their attitude towards the risk involved in bond holding.
His analysis also based on uncertainty but different
from Keynes idea of uncertainty
�According to Tobin individuals are uncertain in their
own minds as to the movement of the rate of interest
and hence are uncertain as to the future value of bond
holding. Hence there is risk involved in bond holding.
�People find the prospect of money income desirable
but not risk. Suppose two options are given to an
individual one a safe one and the other a risky option
with the possibility of getting more money but an equal
possibility of getting less than the safe option. Which
will he choose? Most people will choose the safe
option but the gamblers and risk lovers will choose the
unsafe option.
�Holding money involves no risk but also no return. In
the case of bond holding there is the return in the form
of interest income but also the possibility of capital loss
in case the rate of interest rises leading to a fall in the
bond value. The problem for the individual is to
balance out the risk and the return elements to band
holding. To explain this he uses indifference curves.
But we need to have measures for risk and return in
order to draw and explain using indifference curves
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�If we assume that the individual is a risk averter he will
only assume more risk if at the same time it increases
his expected return. His indifference curve will slope
upwards from left to right..
�Impact of a change interest on the portfolio of a risk
averter. Suppose rate of interest i increases. The
opportunity line OB shifts to OC which becomes
tangential to a new indifference curve 3 at point X.
This will result in a change in the portfolio with an
increase in bond holding and a reduction in cash.
�This is because of the combined effect of the
substitution and the income effect. Substitution effect
will be positive. Income effect could be negative or
positive.
Income and the Substitution Effects
�Critical Appraisal of Tobin’s theory
�Superior to the Keynesian theory as it provides an
explanation for the interest elasticity of demand for
money that does not depend upon speculators being
certain in their minds regarding the course of the rate of
interest.
�It can also provide a reason why some people have a
positive relationship between their demand for money
and the rate of interest.
�It provides an explanation for why portfolios of
individuals maybe diversified
� Demerits
� 1. Incomplete Theory –only one alternative to money

name bonds. But there are a variety of ways in which

wealth can be stored. Assets can be distinguished on
the basis of maturity example short term and long term
maturities.
� They could also be distinguished on the basis of the

risk and convenience of encashment etc.

� 2.Oversimplified in assuming that cash is riskless.
� 3. Concerned with individual financial behavior and is

not applicable to insitutional investors.

� 4. Tobin’s assumption that the wealth elasticity of

demand for money is unity.

� 5. Too involved and incomplete