Chapter 22, Problem 14Q

To determine

In case the question requires us to explain the four factors that determine the demand for money according to the portfolio theory.

Concept Introduction:

Portfolio theory: American economist James Tobin justified that rational individuals will keep portfolio of consisting of money (cash) and bond rather than keeping wealth either in money (cash) or bond. According to Tobin, people are in general risk averse. Human behaviour demonstrates risk aversion. This implies that, they have a preference towards lesser risk at a given rate of return. In the Keynesian analysis, the wealth of a person is either in the form of all money or all bonds depending on his expectation of the future rate of interest. According to Tobin, faced with various safe and risky assets, individuals prefer to diversify their portfolio by sharing their wealth in a balanced combination of safe and risky assets. According to him, an investor is confronted with a dilemma of what quantity of his portfolio of assets should be in the form of money (without any interest) and interest-earning bonds. Portfolio theory highlights the function of money as a store of value. Money presents a blend of risk and return as compared other assets which are less liquid than money — such as bonds.

According the money portfolio theory, demand function of money is expressed as:

(M/P)_d = f(r_s, r_b, p_e, W)

Where r_s = the expected real return on stock, r_b = the expected real return on bonds, p_e = the expected inflation rate and W= real wealth.

The four factors that determine the demand for money are:

1. Expected real return on stocks (r_s)
2. Expected real return on bonds (r_b)
3. Expected inflation rate (p_e)
4. Real wealth (W)