Tobin’s Portfolio Approach to Demand for Money –
James Tobin, an American economist, in his analysis makes a valid assumption that people prefer more wealth to less. According to him, an investor is faced with a problem of what proportion of his portfolio of financial assets he should keep in form of ready money (which earns no interest) and in form of investment (which earns interest) such as bonds. An individual’s portfolio may also consist of more risky assets such as shares.
According to Tobin, when individuals are faced with various safe and risky assets, they diversify their portfolio by holding a balanced combination of safe and risky assets.
According to Tobin, individual’s behavior shows risk aversion, which means they prefer less risk to more risk at a given rate of return.
If an individual chooses to hold a greater proportion of risky assets such as bonds or shares in his portfolio, then he will be earning a higher average return but will bear a higher degree of risk. Tobin argues that a risk averter will not choose such a portfolio with all risky bonds or a greater proportion of them.
In the other case, an individual who, in his portfolio of wealth, holds only safe and riskless assets such as money in form of cash or demand deposits, he will be taking almost zero risk but will also be geting no return. Therefore, people prefer a mixed or diversified portfolio of money, bonds and shares, with each person opting for a little different balance between risk and return.
Tobin’s Liquidity Preference Function –
Tobin derived his liquidity preference function showing relationship between rate of interest and demand for money. He argues that with the increase in the rate of return on bonds, individuals will be attracted to hold a greater proportion of their wealth in bonds and less in form of ready money.
At a higher rate of interest, the demand for holding money will be less and people will hold more bonds in their portfolio and vice versa.
In Tobin’s portfolio approach demand function for money as an asset slopes downwards, where horizontal axis shows the demand for money and vertical axis shows the rate of interest.
The downward sloping liquidity preference function curve shows that the asset demand for money in the portfolio increases as the rate of interest on bonds falls. In this way Tobin derives the aggregate liquidity preference curve by determining the effects of changes in the interest rate on the asset demand for money in the portfolio of peoples.
Tobin’s liquidity preference theory has been found to be true by the empirical studies conducted to measure interest elasticity of the demand for money as an asset.