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Book Name – Macroeconomics (HL Ahuja)
What’s Inside the Chapter? (After Subscription)
1. TOBIN’S PORTFOLIO APPROACH TO DEMAND FOR MONEY
1.1. Tobin’s Liquidity Preference Function
1.2. Evaluation
2. BAUMOL’S INVENTORY APPROACH TO TRANSACTIONS DEMAND FOR MONEY
2.1. Baumol’s Analysis of Interest-Responsiveness of Transactions Demand
3. FRIEDMAN’S THEORY OF DEMAND FOR MONEY
3.1. Wealth (W)
3.2. Rates of Interest or Return (rₘ, rᵦ, rₑ)
3.3. Price Level (P)
3.4. The Expected Rate of Inflation (AP/P)
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Post-Keynesian Theories of Demand for Money
Chapter – 22
By introducing speculative demand for money, Keynes departed from the classical view which emphasized only transactions demand.
A major criticism of Keynes’ theory is that it assumes individuals hold wealth entirely in money or entirely in bonds, which is unrealistic since people usually maintain a diversified portfolio of assets.
This limitation led to the development of the portfolio approach to money demand by James Tobin, William Baumol, and Milton Friedman, who viewed wealth as distributed among money, bonds, shares, and physical assets.
Unlike Keynes, who considered transactions demand for money as interest-inelastic, Baumol and Tobin demonstrated that even transactions demand is interest elastic, as individuals adjust cash holdings in response to interest rate changes.
These post-Keynesian theories provide a more comprehensive and realistic explanation of money demand by incorporating asset diversification and interest sensitivity.
TOBIN’S PORTFOLIO APPROACH TO DEMAND FOR MONEY
James Tobin argued that rational individuals hold a diversified portfolio consisting of money, bonds, shares, and other assets, rather than keeping all wealth in either money or bonds as suggested by Keynes.
Investors prefer more wealth to less and must decide what proportion of assets to keep as riskless money (earning no interest) and as interest-bearing but risky bonds or shares.
Tobin emphasized risk aversion, stating that individuals prefer less risk to more risk at a given level of return and therefore avoid holding all wealth in risky assets despite their higher average returns.
Holding only risky bonds may yield higher returns but involves greater uncertainty about future interest rates, while holding only money ensures safety but provides no return or wealth growth.
To balance safety and return, individuals choose a mixed portfolio of safe (money) and risky (bonds, shares) assets, with the exact combination depending on personal attitudes toward risk and the trade-off between risk and return.