TOBIN’S THEORY OF PORTFOLIO DM

Prof. Prabha Panth,Osmania University,

Hyderabad

KEYNES DEMAND FOR MONEY

• Keynes assumed that public holds its assets either as bonds or cash.

• Tobin has criticised this assumption.• People hold their assets or wealth in

many forms – or in various “Portfolios”• This includes:

a) Money, b) Bonds, c) Property, etc.• Transaction DM may also be affected by

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Tobin’s Portfolio DM

• According to Tobin, people hold a Portfolio of Assets – some cash, and some bonds.– Idle cash is safe (no risk), but earns zero

income or interest.– Bonds earn interest, but they are risky.Therefore people hold a balanced

combination of both safe and risky portfolio of assets.

Depends on the individual’s attitude to Risk.

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Tobin’s Portfolio DM

• According to Tobin, individuals show “Risk Aversion”.

• They prefer less risk to more risk at a given rate of interest.

• Also, they are uncertain about the future rate of interest

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Tobin’s Portfolio DM

• But holding cash is unproductive, as it earns no income.

• So they have to choose a combination or portfolio of assets – some less risky (safe) but less productive-- some more risky but more productive.

The portfolio of assets depends on the nature of the individual

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Tobin’s liquidity preference curve• Like Keynes, Tobin shows the LP is

inversely related to rate of interest.• When i is high, people change their

portfolio to bonds, and hold less cash• When i is low, they prefer to hold

cash, and reduce the number of bonds.

• Thus the Asset DM is inversely related to the rate of interest.

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Tobin’s liquidity preference curveR

ate

of in

tere

st

Asset D for Money

0

DM

Asset D for Money

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Tobin’s Model

rs = expected real return on stocksrb = expected real return on bondsp e = expected inflation rateW = real wealth

( / ) = ( , , , ),d es bM P L r r W

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Tobin’s Model• Stocks and bonds are alternatives to money. • An increase in i makes money less attractive,

reduces desired money holdings. • The real return to holding money is -e. • An increase in e is decrease in real return to

holding money, and cause a decrease in desired money balances.

• And finally, an increase in wealth causes an increase in the demand for all assets.

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