Question

Within Tobin’s theory of the demand for money, explain how the optimal portfolio (the choice of money and bond demand) would be affected by an increase in uncertainty about the price of bonds.

- Please give brief explainations, Thanks a lot in advance

Answer 1

Ans: Tobin's Portfolio balance approach deals with the demand for money. It states that every individual maintains a combination of money and bonds. no individual prefers to keep just cash or just bonds. their portfolio consists of both money and bonds. But, by its nature, bonds are risky assets and money is a safe asset. Also, bonds yields return whereas money yields no returns. Therefore, if we assume a person who is risk averse, he would prefer a portfolio which yields higher returns with minimum risk. Therefore, if the prices of the bonds are uncertain, an individual will be exposed to a greater degree of risk as well as a greater degree of return. thus, an individual prefers more money as their liquid asset than bonds where there is an uncertainty of the price of the bonds.